Accrual Accounting vs Cash Accounting

Table of Contents

Accrual Accounting

Definition: Accrual accounting is an accounting method where revenue or expenses are recorded when a transaction occurs rather than when payment is received or made.
- The Accrual Accounting method follows the matching principle, which says that revenues and expenses should be recognized in the same period.
- Accrual accounting is one of two accounting methods; the other is cash accounting.

Definition: Cash accounting is the other accounting method, which recognizes transactions only when payment is exchanged.
- The cash accounting method records revenue and expense transactions when the payments are physically received or paid out.
- This method is restricted to small businesses that do not have significant volumes of transactions.
- The advantage of this method over the accrual method of accounting is that a business can account for all the physical money it has on hand.
Limitation of Cash Accounting Principle:
- If the business sells goods on credit through internal financing, then it would be unable to account for future payments, since cash accounting, unlike the accrual accounting method, does not have a means of recording future payments.
- Therefore, a business that uses the cash accounting method may not always present the most accurate view possible of its real financial position.

Increasing Complexity of Businesses: Large companies that sell goods on credit may continue to receive revenue over a long period of time from goods that were sold earlier.
- Recording such transactions when the payments occur would reflect an inaccurate picture of the company’s financial position, whereas the financial markets require timely and accurate reporting of a company’s finances.
- With the accrual accounting method, large businesses can present the most accurate picture of the financial position of the company.
For performance measurement in a particular period: It helps businesses to examine their actual performance during a certain period of time- such as a quarter or one fiscal year.
- It provides the most accurate picture of a company’s performance over a specific period of time as future revenues and expenses can be accounted for.
- The financial information recorded under accrual accounting enables the business to calculate key financial metrics such as gross profit margin, operating margin, and net income.

Accrual accounting may indicate that a business generated profits during a specific accounting period while the recorded cash flows are yet to be received.
Potentially, it can portray the business as profitable even when it lacks sufficient cash flow to finance its operations.
In cases of extreme cash flow shortages, the business may even become bankrupt despite showing current profits per its financial statements.
For example: Suppose that XYZ Company never makes a payment for the construction materials?
- Such a situation would present a genuine and substantial financial problem for company ABC, but it would also present the company with a significant accounting problem.