Accrual accounting is considered a more powerful tool for managing the finances of a business. But cash accounting is still necessary for some functions. The key difference between cash basis and accrual basis accounting is timing — when revenue or expenses are recorded. The cash option leans toward a more immediate recognition of revenue and expenses, while the accrual method focuses on anticipated revenue and expenses.
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Cash Basis Accounting
Only when money changes hands do businesses apply cash basis accounting. Sent invoices or bills do not count until they have been settled. Any form of payment — not necessarily cash, as implied by the name of the term — is taken into consideration when performing cash basis accounting.
Cash basis accounting is less complex and it shows how much money the company has on hand. However, it is not an accurate reflection of the business’s profitability as bills and expenses are not factored. Making management decisions, for example, will require a bigger picture of the company’s finances.
Accrual Basis Accounting
Accrual basis accounting recognises income once a customer has been invoiced, and it recognises a bill or an expense as soon as it comes in, even though payment will only be made in the near future. Even though a company needs to put in more effort, and may have to pay tax on income before a customer pays up, a company will have a much more accurate picture of business performance and finances, and longer term finance, even managerial, decisions can be made with more confidence.
A hybrid method is adopted by many business, taking full advantage of the benefits of both systems. Big financial decisions involving loan applications, for example, can be based on accrual, and cash-basis accounting can be applied to some elements for the purpose of tax filing, as the tax year for which income and expenses are recorded will be different and can make a difference in a company’s management of finances for a particular tax period.