Q&A: Cash basis vs. accrual accounting

This is a question I received by email, which seems worth answering for others as well.

Question: What are the uses of both accrual and cash-basis accounting?

 

Answer:

Cash-based accounting is very simple,
but not as useful. It records cash transactions only, and ignores
everything else. It works only for very simple businesses that never
buy anything on credit to be paid later, never offer customers credit,
and don’t manage inventory. With cash-basis accounting there are no
accounts payable, no accounts receivable, and no inventory.

Accrual
accounting is much more widely used and accepted by businesses because
it properly reflects real business finances. For example, if you sell a
service to a business customer who pays you a month later, you record
the sales amount at the time of delivery of the service, as sales.
Since you don’t have the money, the amount owed to you is recorded as
accounts receivable. Also, if you order a bunch of stuff to sell in
your store, you record the stuff as inventory when it arrives, and if
you pay it a few weeks later, it’s accounts payable until you pay it.
It doesn’t become cost of sales until you sell it. Before that, it’s
inventory.

The very important advantage of accrual accounting is that you know
more about your real financial position. Your books show how much
customers owe you, how much you owe to your vendors, and how much
you’ve spent on inventory. As a business owner, I want to know how much
I owe, not just keep it in my head until I pay it. I want it showing on
the books.

The disadvantage of accrual accounting is it’s more complex. I’m
very much in favor of accrual though, because I want that accurate
picture of my finances.

— Tim