This week in class, I read Accounting Made Simple by Mike Piper. In Chapter Nine, the topic of cash accounting versus accrual accounting was discussed. For a person who wants to start a business, big or small, this is a very important topic to think about. In this essay, I am going to compare cash and accrual accounting and decide which one is better.
Cash Accounting
Cash accounting is extremely simple, and if you are a teenager who lives with their parents and have no bills to worry about, you probably use this way of accounting. When using the cash accounting method, revenue is only recorded when cash is received and expenses are only recorded when cash is paid. This method is great for small, cash based businesses that carry little to no inventory. It is also very easy to manage, meaning you can take care of it on your own and will not have to spend money on outsourcing the task of bookkeeping. However, this method does not always show the full picture and open payments will often be forgotten.
Accrual Accounting
Accrual accounting is a little more complicated than cash accounting, but it is still effective. Revenue is recorded when earned not when cash is received, and expenses are recorded when incurred, not when cash is paid out. This method does not track cash flow, but it does track open payments, unlike cash accounting.
Example
To make this clearer, imagine you have a lemonade stand and you use the cash accounting method. You bring 20 glasses to the stand every day and sell each glass for $1. One day, your friend comes to the stand and asks for 10 glasses of lemonade, but cannot pay you the $10 today. Your friend promises to pay you back tomorrow, and you agree to sell the lemonade to them. The day continues and you sell the last ten glasses before going back home. When you count the money, you see that you made $10 even though you sold $20 worth of lemonade. Since you have not received the $10 from your friend yet, it does not get accounted for.
I am sure you can understand how this is not a good accounting method for bigger businesses that deal with more money and inventory. It is never good to have ‘missing money.’
However, if you used accrual accounting on this situation, you would account for the open payment (the ten lemonade glasses) and your statement would show that you did make $20 for the 20 glasses.
Conclusion
As you can see, both methods have their benefits and their shortcomings. Personally, I think both methods are good. If you plan on having a small business and not deal with open payments, the cash accounting method will meet all your needs. But for bigger businesses that use open payments, it is in their best interests that they use accrual accounting.
Thanks for reading!
Sophia Elahi RPC Blog 