The two primary methods of accounting that are normally used today are Cash and Accrual Accounting. There are differences between both methods. However, the main distinction is on the timing when the revenue or expense is recognized.
Cash accounting simply reports revenue and expenses the moment they are received and paid respectively. On the other hand, accrual accounting, reports revenues and expenses as they are earned and expenses as they are incurred.
Effect of using these methods in your business:
If you are a small business with no inventory, you may opt to use cash basis accounting considering that it is simple to maintain and this method does not recognize accounts receivable and payable. This method is useful for tracking the cash flow of the business. Taxation-wise, under this method the transactions are not recorded until received or paid hence a business’ income isn’t taxed until it is received. However, this method also has a disadvantage. This might overstate the health of a company. For example, the Company may have a large amount of cash recorded since it does not recognize Accounts Payable, its payables might have exceeded the cash recorded and the company’s revenue stream for a certain period.
Accrual accounting is the most commonly used method, especially by publicly-traded companies. One of the advantages of using accrual accounting is that it records accounts receivable and payable that provides an accurate picture of the company’s profitability. However, accrual accounting does not provide any mindfulness on a company’s cash flow. It might not account for a business with a major cash shortage in the short term despite appearing to be profitable in the long term. Under these terms, the company might get affected if it does not properly monitor its cash flow.
Present and future businessmen should properly be equipped with this because sometimes it is fundamentally overlooked in establishing their future businesses. Both methods have pros and cons. The ultimate goal of learning this knowledge, is to maximize within the bounds of the law the advantage of the method of accounting chosen.
