Businesses use different accounting methods to maintain their financial records. The cash accounting method only records a financial transaction if the company pays or receives cash. The accrual accounting method records financial transactions when the activity occurs, regardless of when the company pays or receives cash. Each method provides different advantages and disadvantages to the company. The business owner who understands these can make an informed decision of which method to use.
The accrual accounting method provides the advantages of comparability and communication, because it communicates the activities that occurred during the period. For example, if the company earned revenue during the current month, this revenue appears on the income statement. The company may not receive payment until the following month, but users of the income statement can see that the company engaged in income-producing activities during the current month. Many companies use accrual accounting because of the communication. Since these financial statements follow the same format, companies who use this method can compare their financial activities with other companies.
Certain accounting standards, including the generally accepted accounting principles, or GAAP, standards essentially required for publicly traded companies, also favor using accrual accounting.
Accrual accounting requires the company to spend more time reviewing transactions and incur additional labor costs. Companies who use accrual accounting need to analyze each account monthly. These companies need to determine if activities need to be recorded because they occurred even though no financial exchange took place. The company needs to pay staff to review these accounts.
Companies who use cash accounting relish the simplicity of this method. The accounts require less analysis since each financial transaction is evidenced by the exchange of cash. Activities do not appear in the financial records unless the company receives payment. The business owner also uses cash accounting for filing his income taxes. This method allows him to use the same information in his tax return.
Cash accounting provides less analytical information for the business owner. The business owner needs to dig into non-accounting data to understand what activities occurred during the month. For example, to analyze the amount of money customers owe the business, the business owner needs to review individual invoices rather than a financial account. Another disadvantage of cash accounting involves the need to restate the information if the company seeks financing or sells stock. Many lenders and stockholders require financial statements which use accrual accounting.