Learn about the nuances of cash-based and accrual accounting, their advantages, and drawbacks. Discover how these accounting types impact a company's financial health and how they are integral in careers related to finance and accounting.
Key Insights
- Cash-based accounting books revenues when money is collected and expenses when paid for, offering simplicity in its implementation.
- Despite its simplicity, cash-based accounting might overstate the health of a company that is cash-rich but has large sums of accounts payables that far exceed the cash on the books and the company's current revenue stream.
- Accrual accounting, on the other hand, records revenues when services or goods are delivered and expenses when they are incurred, irrespective of the payment date.
- Accrual accounting provides an accurate picture of a company’s profitability, especially in the long term, as it includes accounts receivables and payables.
- However, accrual accounting is more complicated to implement since it requires accounting for items like unearned revenue and prepaid expenses.
- The accrual method is the most commonly used method, especially by publicly-traded companies as it smooths out earnings over time.
| When revenue is recognized | |
|---|---|
| Cash Accounting | When cash actually changes hands — simple, used by small businesses. |
| Accrual Accounting | When earned/incurred regardless of cash timing — required by GAAP for most companies. |
Cash-based accounting is what we would intuitively think of: revenues are generated when we collect money, and expenses are incurred when we pay for them
Accrual accounting books revenues when services or goods are delivered (not when they are paid for), and expenses when they are incurred (not when they are paid for)
For example, a company delivers a service but has not received payment yet, revenue would still be recorded. The money owed would be booked as accounts receivable as an asset on the company’s balance sheet.
On the flip side, if a company collects cash for a service it has yet to deliver (for example, an airline collects ticket fare three months prior to the travelers’ flight) the collected cash would not hit the company’s revenue (until the date of the customers’ flight). That is known as unearned, or deferred, revenue, which would show up as a liability on the company’s balance sheet because the company owes the service.
The accrual method is the most commonly used method, especially by publicly-traded companies as it smooths out earnings over time.
Cash-Based
Advantage: Simplicity—it only accounts for cash paid or received
Disadvantage: It might overstate the health of a company that is cash-rich but has large sums of accounts payables that far exceed the cash on the books and the company's current revenue stream
Accrual
Advantage: It includes accounts receivables and payables and, as a result, is a more accurate picture of the profitability of a company, particularly in the long term
Disadvantage: More complicated to implement since it's necessary to account for items like unearned revenue and prepaid expenses
Video Transcription:
Full Video Transcript
Cash-Based Accounting Fundamentals
Let's talk about cash versus accrual accounting. Cash-based accounting is what we would intuitively think of. Revenues are generated when we collect money, and expenses are incurred when we pay for them.
Accrual accounting books revenues when services or goods are delivered, not when they are paid for, and expenses when they are incurred, not when they are paid for. For example, a company delivers a service but has not received payment yet. Revenue would still be recorded, and the money owed would be booked as accounts receivable as an asset on the company's balance sheet.
Deferred Revenue and the Accrual Method
On the flip side, if a company collects cash for a service it has yet to deliver, for example an airline collects ticket fare three months prior to the traveler's flight, the collected cash would not hit the company's revenue until the date of the customer's flight. That is known as unearned or deferred revenue, which would show up as a liability on the company's balance sheet because the company owes the service. The accrual method is the most commonly used method, especially by publicly traded companies, as it smooths out earnings over time.
Advantages and Disadvantages of Cash-Based Accounting
Let's take a look at key differences between cash-based and accrual accounting. An advantage of cash-based accounting is simplicity. It only accounts for cash paid or received. A disadvantage here is that it might overstate the health of a company that is cash rich but has large sums of accounts payables that far exceed the cash on the books and the company's current revenue stream.
Advantages and Disadvantages of Accrual Accounting
An advantage of accrual accounting is that it includes accounts receivables and payables, and as a result is a more accurate picture of the profitability of a company, particularly in the long term. A disadvantage of accrual accounting is that it doesn't track cash flow, and as a result might not account for a company with a major cash shortage in the short term despite looking profitable in the long term. Also, it's more complicated to implement accrual accounting since it's necessary to account for items like unearned revenue and prepaid expenses.
