The primary difference between the two principal business accounting methods, accrual accounting and cash accounting, is when revenue and expenses are recorded as taking place.
Accrual accounting is the most common accounting practice for corporations. Businesses with annual revenues in excess of $5 million are required to use the accrual method for tax purposes. The impetus for using the accrual method of accounting comes from increasingly complex business transactions, such as selling on credit and extended contracts that continue to provide revenue for a company over a long span of time, and the financial market's desire to have more timely, accurate information on a company's financial situation. This accounting method aims to provide the most accurate, current picture of a company's financial condition.
The accrual method is essentially a matching up of revenues to expenses when the transaction takes place instead of when payment is processed or received, which is the cash basis accounting method. Because income is recorded and reported when goods are delivered or services are rendered rather than when payment is actually made, it is necessary to factor in a "non-payment allowance," commonly an estimated amount that takes into account the fact that some customers/clients fail to pay. (For more, see "How to Decipher Accrual Accounting.")
In cases wherein payment is received prior to goods or services actually being provided, a company initially lists the payment as a liability. The company is liable to deliver the goods or services. Once the good or service is provided, the payment is shifted from being listed as a liability to being listed as revenue for the company. Expenses are handled in the same manner as revenues; as soon as a bill is received, it is recorded as a company expense rather than being recorded after the company actually makes payment.
The cash accounting method is almost exclusively restricted to very small businesses and can work perfectly well for a sole proprietor with a home business. In the modern economy, it is difficult for any standard business to operate on a cash accounting basis. For example, cash accounting simply does not work for a retail operation that sells goods on credit through in-house financing, as it does not provide any means of recording money due from a customer at some future date. The cash method accounts for all revenue and expenses when cash physically changes hands.
Cash basis accounting is simple, straightforward and provides a clear picture of the actual money the company has on hand. In this respect, it is superior to accrual accounting, which does not provide an accurate report of cash on hand. To overcome this problem, companies that use accrual accounting usually have a system set up to monitor cash flow. A weakness of cash accounting is since it does not record future liabilities – bills due but not yet paid – it may paint an inaccurately positive view of a company's current financial condition.
(For related reading, see "When Is Accrual Accounting More Useful Than Cash Accounting?")