Accrual or Cash accounting?
- Accrual accounting records revenue and expenses when transactions occur but before money is received or dispensed while Cash accounting records revenue and expenses when cash related to those transactions actually is received or dispensed. The cash method provides an immediate recognition of revenue and expenses, while the accrual method focuses on anticipated revenue and expenses.
- Accrual accounting provides a more accurate view of a company’s health by including accounts payable and accounts receivable and it is the most commonly used method by large publicly-traded companies as it smooths out earnings over time. The cash basis method typically is used by sole proprietors and smaller businesses. In accrual basis, a company might look profitable in the long term but actually have a challenge with major cash shortage in the short term unless Cash flow statement is prepared and analyzed for quick action. Another limitation of the accrual method is that it can be more complicated to use since it’s necessary to account for items like unearned revenue and prepaid expenses which may require a skilled accounting personnel.
The key advantage of the cash method is its simplicity—it only accounts for cash paid or received. Tracking the cash flow of a company is also easier. However, this method might overstate the health of a company that is cash-rich. That’s because it doesn’t record accounts payables that might exceed the cash on the books and the company’s current revenue stream. As a result, an investor might conclude the company is making a profit when, in reality, the company might be facing financial difficulties.
The cash basis method is not acceptable under GAAP.
Special Considerations
The accrual method is the more commonly used method, particularly by publicly-traded companies. One reason for the accrual method’s popularity is that it smooths out earnings over time since it accounts for all revenues and expenses as they’re generated. The cash basis method records these only when cash changes hands and can present more frequently changing views of profitability.
For example, under the cash basis method, retailers would look extremely profitable in Q4 as consumers buy for the holiday season. However, they’d look unprofitable in the next year’s Q1 as consumer spending declines following the holiday rush.
Both methods have their advantages and disadvantages. Each provides different views of the financial health of a company. For investors, it’s important to understand the impact of both methods when making investment decisions.
