Accounting and bookkeeping services involve maintaining up-to-date accounts, including journals, ledger, and subsidiary books. These books further help prepare financial statements like cash flow, income statement, and balance sheet, representing the company’s financial health and performance. It also facilitates tax preparation and lodging with appropriate authorities. The entire system requires compliance with accounting standards, principles, tax, legal rules, etc.
A company must choose one of the two revenue recognition accounting methods available per the accounting standards. These two methods are:
- Cash basis of accounting
- Accrual basis of accounting
Most companies choose the latter as it is more beneficial in accounting services and represents an accurate and fair picture of its financial health. At the same time, the former is suitable for micro firms with fewer transactions. Before we dive deep into both, let us first understand their meaning and differences:
- Cash basis of accounting:
It is the simplest accounting method. Here, transactions get recorded in the right books only when a cash inflow or outflow occurs from one party to another. There are no accounts payable or accounts receivable in this method. Since there are no credit or debit balance accounts except cash, it is easy to track money flow. Small or micro firms with a handful of transactions or those who deal only on money and not credit can apply this method. A business can look at its bank or cash balance to determine its availability. Also, such firms do not have to pay tax unless cash flow occurs.
- Accrual basis of accounting:
Under the accrual accounting method, a company records an expense when incurred and income when earned. Here, the flow of money is irrelevant. It recognizes financial transactions as soon as they occur without waiting for cash flow to happen- for example, purchasing goods on credit or selling them on credit. It is a commonly used method among businesses as it paints a realistic picture. It offers a long-term view of your expenses and incomes. However, it requires effective monitoring; otherwise, firms may not have an optimal cash flow but depict an excellent financial picture.
A side-by-side difference table will make it more transparent:
Cash basis Accrual basis
- Expense recognized when cash outflows Expense recognized when incurred (irrelevant cash flow)
- Income recognized when cash inflows Income recognized when earned (irrelevant cash flow)
- Tax paid only for money received tax paid for the money you still haven’t received
- Suitable for micro firms dealing in cash with no inventory Suitable for firms dealing in credit
Effects of cash and accrual accounting:
To understand the differences between the two methods of accounting and bookkeeping services, let us look at a few examples:
- Sent invoice for a job finished this month- amount $5,000
- Received a bill for work done this month- amount $1,000
- Paid $800 for an account received last week
- Received $1,000 from a customer for an invoice sent the previous month
Let us take a look at the effect of these transactions on:
- Cash flow:
Under the cash basis of accounting and bookkeeping services, the net profit gets reflected as 1,000- 800= $200.
Under accrual accounting, profit gets determined as 5000- 1000= $4000.
It displays the difference between cash flow and accounting stream. The former only considers cash flow while the latter does not.
- Taxes:
The tax period is also different for cash and accrual basis of accounting. Since income is the only constituent in determining tax liability for the former category, it is usually less. However, accrual accounting, tax filing, and lodging involve amounts the company hasn’t received yet. The outstanding expenses and prepaid income become due when recognized.
- General processes:
The accrual basis of accounting and bookkeeping services requires maintaining payables and receivables subsidiary book instead of the cash basis of accounting. Although both methods require reconciliation, it gets complicated in accrual accounting. In the latter, companies need to protect the receipts of disbursements and income from getting stolen or misplaced. They have to keep tabs on short-term cash flow in accrual. A startup can go for cash accounting for simplicity, but once it starts growing and investing in long-term assets and liabilities, it needs to switch to accrual.
- Role of accounting software:
Accounting software offers an all-in-one package with multiple features supporting the accrual basis of accounting. Since the cash basis of accounting is pretty simple and easy to do because of low transactional volume and negligent assets and liabilities, accounting software would be a waste of money and time.
The accrual basis of accounting and bookkeeping services involves many aspects. There are journals, ledgers, various assets, liabilities, nominal accounts like expenses and incomes. Firms need to ensure constant upkeep of these accounts with proper amounts for financial statements and tax filing. Since the manual accrual method becomes a tedious and cumbersome process, accounting software provides speed and efficiency and expedites other processes.