You’ve come across cash and accrual accounting, but are you unsure of the difference between the two? Differentiating between cash and accrual accounting might seem difficult, but it doesn’t have to be.
The difference is distinguished based on when the timing of the purchases was noted. With cash basis accounting, the expenses and revenue are recorded only when there is evident cash.
With accrual accounting, the expenses and revenue can be recognised even when they have not been released yet, for instance, an invoice for a future payment falls under accrual accounting, whereas cash accounting would not record that payment until it’s received.
Who Should Use Cash Accounting?
Cash accounting is most suitable for small businesses that want to easily manage cash flow or make below a certain revenue threshold.
In South Africa, the only businesses allowed to use cash basis accounting are sole owners and partnerships that have a turnover of less than R 2,5 million. Additionally, national and provincial governments use a modified cash basis form of accounting.
How Does Cash Accounting Work?
To look at cash accounting practically, look at the following example:
Business X has a printing shop and prints t-shirts for client Y, who they’ve had a long-term working relationship with. The cost of printing 250 t-shirts is R 42 000. Business X sends out an invoice to client Y on March 3, however, the payment terms only require the client to pay within 14 days.
Client Y only makes the payment on 16 March. With cash accounting, the payment is not recognised on March 3 when the invoice was sent, but it is recognised on 16 March when the payment has been received.
Benefits of Cash Basis Accounting
- Simpler bookkeeping processes which allow you to manage the finances on your own.
- Allows you to easily manage your business’s cash flow.
- Income is only taxed with recognised payments. SMEs can deduct their expenses in the year they are paid, even if the expenses were for the previous year.
Disadvantages of Cash Basis Accounting
- Does not provide an accurate view of your business’s finances.
- Does not provide a view of long-term finances of your business, making it harder to plan for certain aspects required to propel your business.
- Delayed recognition of your expenses, since expenses like bills are only recognised when they are paid.
Who Should Use Accrual Accounting?
The term accrual refers to the accumulation of something over a certain time. In the context of finance, refers to the gradual accumulation of accrued payments over a period of time. If you’re the sole owner of a business or in a partnership with a turnover of more than R 2,5 million, you are required by law to use accrual accounting.
Additionally, if the nature of your business doesn’t typically deal with immediate payments. For instance, if you have a service-based business and long-term clients where projects take months or are continuous for years.
Benefits of Accrual Accounting
- Provide stakeholders with a clear view of your finances.
- Gives businesses the opportunity to analyse their finances and assess whether they can afford to provide the services/goods they provide or take on any new projects.
- You get to view your finances in real time.
- Suitable for long-term partnerships and large amounts of money.
Disadvantages of Accrual Accounting
How Does Accrual Accounting Work?
Let’s refer back to the scenario we mentioned earlier. Business X has a printing shop and prints t-shirts for client Y. They have printed 250 t-shirts for R42000. Business X sends out an invoice to client Y on March 3, giving the client a deadline of 14 days to make payment.
Client Y only makes the payment on 16 March. With accrual accounting, the payment is recognised even when there is an anticipated payment, such as an invoice, so, when the invoice is sent out on March 3, the expected amount will be recorded.
Which Accounting Method Is The Best for Your Business?
The best method to use is dependent on the type of business you have and the needs of your business. If you run a small business that focuses on short-term cash flow, cash accounting might be the best method for you.
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