Types of Financial Accounting: An In-depth Guide

Financial accounting is a branch that prepares financial statements that provide a clear view of the company’s financial state. These financial statements are largely used by the external stakeholders, usually the investors, creditors, regulators and analysts, to make informed decisions. All financial accounting must follow standardized rules to make financial figures comparable and transparent among different businesses.

What is Financial Accounting?

Financial accounting is recording an organization’s financial activities and making these records in written form to ascertain an organization’s financial performance. Thus, external financial account users (investors, creditors, analysts, and regulators) should use financial accounts (such as balance sheets, income statements, and cash flow statements) based on these financial accounts.

It is one of the accounting disciplines that follows generally accepted legal and professional methodologies such as GAAP or IFRS, so the results of different businesses and industries can be easily compared. Briefer, but still used in the broadest sense, financial accounting means narration of such operations results and changes in the financial condition of an organization during a period to avoid misleading the better-informed readers through omission or commission.

• Cash Accounting: This method of recording the transaction when it occurs in cash.  This accounting method works when the company records income after receiving cash from sales. This requires transaction recording only when money moves in and out of the bank account.

• Accrual Accounting: This method of recording the transactions, whether earned or incurred. Businesses use accrual-based accounting to create journal entries for sales and expenses before collecting or making payments.

What is Accrual Accounting?

Accrual Accounting is a system of recording revenue and expenditure when earned or payable, irrespective of the actualisation of cash transactions. It also provides a clearer and more efficient picture of how a company fares financially at a given time.

Why is Accrual Accounting Important?

Let’s discuss some reasons why accrual accounting is so important.

• Accurate Financial Reporting: Accrual accounting records revenue and expenditure when earned or when a sum becomes due. This makes it possible to obtain financial statements that are as close to a representation of the position of a business as possible on a given date.

• Better Decision-Making: Recognition of revenues and expenses allows managers and stakeholders to make prudent decisions in investments, operations, and strategic initiatives.

• Compliance: Most companies in different parts of the world adopt accrual accounting when preparing their reports for regulatory bodies and financial statement preparation.

• Matching Revenues with Express: Most companies in different parts of the world adopt accrual accounting when preparing their reports for regulatory bodies and financial statement preparation.

• Supports Long-Term Planning: Accrual accounting is also important because it allows business planning and controlling of resources that future revenue and cost obligations help identify.

Benefits of Accrual Accounting

Let’s discuss some benefits of accrual accounting.

• Accurate Financial Reporting: Accounts revenues and expenses are recognized when received or paid out, respectively, giving proper commendation of economic activity. This does away with these problems arising from the nature and timing of cash flows.

• Better Financial Planning and Decision-Making: Accrual accounting information offers anticipation of future receivables and amounts payable and, as such, assists in cash flow planning, budgeting and resource management.

• Matching Revenues and Expenses: Being historical and giving the picture of profitable volumes within a specified time, accrual accounting adjusts its expenses and revenues within the matching principle. This is very important when analyzing the performance of businesses.

• Facilitates Investor Confidence: Audited and Argentine-Argent uniform forms of financial statements give investors and stakeholders more visibility. This increases confidence in the affairs of the company, thereby RT.

• Enhanced Creditworthiness: Managers and analysts use accrual-based financial statements since they present details of the flexibly accrued value of the liabilities and receivables of a company to the lenders and financial institutions.

Types of Accrual Accounting

• Revenue Accrual: Sales revenue is reported when realised, whether or not the cash has been received from customers. This means that revenue is appropriately matched with the period in which the goods or services were rendered.

• Expense Accrual: Right recognition and timing in recognition of revenues and expenses are important for managers and decision-making to make profitable and economical decisions based on investment, operations, and strategic activities.

• Accrued Revenue: Revenue that has been billed and is earned but has not been recorded in the accounts. This accrual type is used in companies that render services that may be paid for after some time.

• Accrued Expenses: Costs that have been used but have yet to be paid or written off. Some of these include utility expenses or salaries, which may be payable in the next period, but the expense will be payable in the current period.

• Interest Accrual: Interest revenue or cost is, therefore, included based on the matching accrual concept and recorded when such revenue is earned or when such cost is incurred, despite when such cash flows might have occurred. This is important for loans or investments. For example, the financier may wish to influence the level of Value that the borrower will provide.

• Tax Accrual: Taxes payable are recognised as an obligation in the period they are for, although payment may be made in the following period. This is important in reporting the institution’s financial status to the financial statement users and in financial forecasting.

Disadvantages of Accrual Accounting

• Complexity in Implementation: It is seen that accrual accounting is even more complicated than cash accounting. It implies identifying and documenting revenues and expenses when they have yet to be realized or even when they are being earned and used, respectively. It takes high skills for an accountant to address these complications or use sophisticated accounting applications that may be expensive to procure and maintain.

• Misalignment with Cash Flow: The first disadvantage, and perhaps one of the most serious, is that it does not indicate the actual flow of cash. High revenues appear on the Income Statement, but where is the money? A company may lack liquidity, although its Income Statement report shows high revenues. Such misalignment causes problems in general organizational work.

• Higher Administrative Costs: The need for precise tracking of accounts receivable and payable and other adjustments like depreciation and amortization leads to higher administrative costs. Small businesses, in particular, may find these additional costs burdensome.

Examples of Accrual Accounting

• In the context of a software company, this refers to entries made at the project’s delivery point to the client, whether or not the money has been collected from the client.

• Expenses are recorded when a retail store obtains inventory from suppliers, regardless of when they are paid.

What is Cash Accounting?

Cash accounting is a method where revenues and expenses are recorded only when cash is received or paid. This approach is simple, straightforward, and commonly used by small businesses or individuals who want to focus on cash flow rather than accrued transactions.

Why is Cash Accounting Important?

Let’s understand “why cash accounting is so important.”

• Simplicity and Ease of Use: Cash accounting is very simple to handle as it involves recording transactions once cash has been exchanged. This makes it suitable for small businesses or even individuals who carry out a few transactions.

• Real-Time Cash Flow Monitoring: It shows businesses’ actual cash inflows and outflows, and only money in and out provides an understanding of the cash position at any given time. This is especially important in managing the day–to–day affairs of the business since one needs to know whether the business is in a position to meet its obligations.

• Improved Cash Management: Cash accounting allows business owners to track available funds easily, helping to prevent overspending and improving cash flow management. This ensures businesses can meet immediate financial obligations.

• Lower Administrative Costs:  Compared to the accrual basis of accounting, this method of accounting means less paperwork and, therefore, lower costs of accounting operations.

• Avoidance of Unrealistic Projections: This Cash accounting avoids overestimating income and expenses since only real cash transactions are recorded. That allows business owners to zero in on real-life financial health instead of projected earnings.

Benefits of Cash Accounting

Cash accounting provides small businesses and individuals simplicity, accuracy, and flexibility. This makes it a popular method.

• Simplicity: Cash basis is easy to use, especially for small companies with limited capital. The only entry it makes is when cash is received or paid; therefore, it is easy to learn and manage.

• Accurate cash flow tracking: The method provides a clear picture of a cash flow position. This helps identify the cash inflows and outflows necessary to manage effective cash flow and make informed financial decisions.

• Reduced paperwork: The problem could be more document-intensive than accrual accounting. It saves small firms huge amounts of time and capital.

• Tax advantages: Cash accounting taxes you only when you get paid because it records revenue and expenses when you receive payment. By keeping future cash receipts in mind, companies can defer the taxes on income until they get cash.

• Flexibility: Because cash-based reporting records income and expenses based on cash exchange, it can readily be modified to fit various ventures of commercial activity. It is ideal for small businesses, entrepreneurs, and anyone who doesn’t need to deal with complex accounting.

Disadvantages of Cash Accounting

• Lack of Accurate Financial Picture: Cash basis accounting records and reports only the actual cash received and expended during a given period; however, no account is taken of outstanding amounts due and payable or amounts owed but not yet received, for instance, accounts receivables and accounts payables, respectively, and this makes it give an incomplete picture of the business at any given period.

• Inability to Match Revenues and Expenses: That means cash accounting fails to follow the matching principle whereby revenues and expenses are recorded only when cash is exchanged, which might result in an insufficient understanding of the business’s actual profitability in a specific time frame.

• Not Suitable for Larger Businesses: Cash accounting is a bothersome enterprise for big companies with advanced operations because it does not provide a complete picture of a company’s creditworthiness, particularly for companies with significant inventories, credit sales or long-term projects.

• Limited Ability for Financial Analysis: Cash accounting doesn’t record receivables and payables, limiting the amount of information it can furnish in making decisions, including assessing future cash flow or financial stability.

• Potential to Mislead Investors or Lenders: Yet still, the cash basis of accounting is less helpful to investors and lenders because the performance of a business needs to reflect accurately, and they might decide wrongly to get loans or invest in a business.             

Examples of Cash Accounting

A construction company wins a major contract but isn’t paid until the project is completed. The company uses cash-based accounting, meaning we can only recognize the revenue after the cash is received — after the project. However, it logs the project spending as paid during project processing. However, if the time of the project is longer than one year, the company’s income statements will seem misleading, showing that the company has incurred large losses one year and large gains another year.

Accrual Accounting vs. Cash Accounting

The comparison of accrual accounting vs cash accounting is in tabular form.

Conclusion

Financial accounting comprises different types of accounting, each with a specific role in presenting useful and transparent financial information. They assist in presenting the business’s financial situation to the stakeholders, hence being helpful in case of compliance and decision-making. It becomes important for every business to have the right knowledge of the various types of financial accounting to ensure future success and, more importantly, obey the laws that govern accounting. To study financial accounting in detail, you can consider pursuing the Certificate Program in Financial Analysis, Valuation, & Risk Management offered by Hero Vired in collaboration with edX and Columbia University.