The recognition of monetary transactions is vital for every business entity, irrespective of its size and nature. There are two accounting systems, through which the transaction can be recognised. They are Cash Accounting and Accrual Accounting. The basic difference between the two approaches to bookkeeping of an entity is in timing, i.e. in cash accounting, the recording is done when there is an inflow or outflow of cash. On the other hand, in accrual accounting, it records the income and expense immediately when it arises. In this article, we will discuss the differences between Cash Accounting and Accrual Accounting.
Content: Cash Accounting Vs Accrual Accounting
|Basis for Comparison||Cash Accounting||Accrual Accounting|
|Meaning||The accounting method in which the income or expense is recognized only when there is actual inflow or outflow of cash.||The accounting method in which the income or expense is recognized on mercantile basis.|
|Method||Not recognized method as per companies act.||Recognized method as per companies act.|
|Income statement||Income statement shows lower income.||Income statement will show a comparatively higher income.|
|Applicability of matching concept||No||Yes|
|Recognition of revenue||Cash is received||Revenue is earned|
|Recognition of expense||Cash is paid||Expense is incurred|
|Degree of Accuracy||Low||Comparatively high|
Definition of Cash Accounting
The basis of accounting in which the recognition of revenues and expenses are done only when there is actual receipt or disbursement of cash takes place. In this method, in which the income or expense is recognised when the inflow or outflow of cash exists in reality.
The method is mostly used by sole traders, contractors and other professionals who recognise their income when there is an inflow of cash and report expenses when cash goes out of the entity.
Moreover, Cash Accounting does not require high knowledge in accounting, a person having little knowledge of bookkeeping can also maintain records as per this system. One of the major benefits of Cash accounting is seen in tax, i.e. expenses and deductions are allowed easily. However, the method is not recommended by the GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Framework) due to a number of drawbacks like:
- It does not coincide with matching concept.
- Time lags in the occurrence of a transaction and its recognition.
- Lacks in accuracy.
Definition of Accrual Accounting
Accrual Accounting is the base of present accounting. It is also known as the mercantile system of accounting wherein the transactions are recognised as and when they take place. Under this method, the revenue is recorded when it is earned, and the expenses are reported when they are incurred.
As per matching concept, the expenses of a particular accounting period are matched with its revenue. The accrual basis of accounting fulfills this criterion; that is why it is regarded as an effective tool for recording receipts and payments. Although, some items are necessary to be adjusted at the end of the financial year like:
- Unearned Income
- Accrued Income
- Prepaid Expenses
- Outstanding Expenses
This method is preferred by most of the entities as the system not only informs about the past transactions regarding the revenue and expense, but it also predicts the cash receipts and disbursements expected to arise in the future. Besides this, one of the major drawbacks of accrual accounting is that the company has to pay tax on the income which is not yet received.
Key Differences Between Cash Accounting and Accrual Accounting
The following are the major differences between cash accounting and accrual accounting:
- The accounting system in which the income or expense is recognised when an exchange of consideration is actually done is known as Cash Accounting. Accrual Accounting, in which the income or expense is recognised when it arises.
- Cash Accounting is simple as compared to Accrual Accounting.
- Cash basis of accounting is not a recognised method as per companies act, whereas accrual basis of accounting is a recognised method.
- In Cash accounting, the income statement, shows lower income, while in accrual basis of accounting the income statement shows relatively higher income.
- Cash Accounting is not in alignment with the matching concept, whereas the concept completely applies in Accrual Accounting.
- The basis of cash accounting is actual receipt and payment of cash. On the other hand, in accrual accounting, the recognition is done when the revenue or expense occurs.
- The degree of accuracy is more in accrual accounting, which is very less in cash accounting.
- Cash Accounting is suitable for sole proprietors or contractors. Conversely, big enterprises should prefer Accrual Accounting.
The gap in the occurrence and recognition of revenue and expense is the main difference between cash accounting and accrual accounting. The former is generally used by a small business person, non-profit organisations and government agencies, etc. while the latter is preferred by the big enterprises because the transactions occur rapidly. The next difference is that the organisations where the records are kept on cash basis accounting enjoy tax benefit whereas in accrual system the entity has to pay tax on the income which is still not collected.