Cash Accounting versus Accrual Accounting
Cash and Accrual Accounting can be a confusing topic because they are very different accounting methods.
This post will highlight how each form of accounting can affect a business in different ways. We will also see how income and cash can be very different things.
The primary difference between Cash Accounting and Accrual Accounting is the timing at which revenue is recorded in the accounts.
An interesting aspect of this is that over time each method will reach the same results. It’s the period between the beginning and the end where differences occur.
This is especially important when it comes to the analysis of financial statements.
Let’s look at each method starting with the easier of the two, Cash Accounting.
Cash Accounting is the more intuitive of the two methods because it only recognizes transactions only when cash is exchanged.
Revenue is only reported on the income statement when cash is received, and Expenses are only recorded when cash is paid.
This makes for a very simple bookkeeping strategy. At the end of the month, you only need to reconcile your bank statement with the transactions that occurred that month.
Under this method, it matters little when the actual work was performed or when an invoice was sent to a customer. What matters is when the customer actually paid you for your product or service.
This also applies to expenses, even when purchasing using credit. The expenses won’t show on your income statement until they are actually paid for.
This can be your chosen accounting method for several reasons:
- It’s intuitive and simple to understand.
- It helps you stay on top of your cash flow; cash being your most important driver for business decisions.
- Because of its simplicity, you can probably perform your own bookkeeping in Excel. This may preclude the need for purchasing specialized accounting software or hiring additional employees with accounting skills.
- It’s an accepted accounting method in most countries for tax purposes. The rules are different from country to country, but Cash Accounting can be applied if a company stays below a certain revenue threshold or the business doesn’t maintain much inventory.
Cash Accounting is a great option for small businesses that are mainly cash-based.
Accrual Accounting is based on when the transaction occurs, rather than when cash is exchanged.
In other words…
- revenue is reported when it is earned and,
- expenses are recorded when they are incurred.
Let’s look at an example of Accrual Accounting.
When will revenue be reported?
Your company sells goods in January but isn’t paid until February.
If we were to use Cash Accounting, the revenue wouldn’t be reported until February when cash was exchanged.
If we were using Accrual Accounting, the revenue would be reported in January when the original transaction occurred.
A Common Question
“If Cash Accounting is so much easier, when do we even bother with Accrual Accounting?”
This is an excellent question. To better understand whey we use Accrual Accounting, let’s revisit an old friend from a previous lecture.
Remember Claudio from the Accounting Basics lecture? Historically, Claudio would travel to his supplier each morning to purchase decorative plates to sell to tourists.
This time, the manufacturer informs Claudio that he wishes to optimize his processes by eliminating the daily cash transactions. Because Claudio has been a loyal and reliable client, he wants to defer the daily cash transaction to a single transaction at the end of the week.
This introduces the concept of credit that will be given to Claudio in order to purchase the decorative plates throughout the week. This will allow for the settlement of purchased during the week to occur on Fridays.
For Claudio, this is a great deal. He doesn’t have to pay right away; he’s working with someone else’s money.
Claudio is now able to expand his business and purchase additional items from another manufacturer with his original cash-on-hand.
In the business world we call this the Leverage Effect.
Claudio decides to purchase 50 hats from a different vendor using his original 100 euros. He pays 2 euros for each hat and plans to sell each hat for 10 euros.
Once Claudio opens for business on the beach, now has 100 decorative plates and 50 hats for sale. The plates will sell for 5 euros each and the hats will sell for 10 euros each.
His friend Mario (who bears an uncanny resemblance to the seller of the decorative plates) really likes the hats Claudio is selling and wishes to purchase 30 hats for an event he is hosting this evening.
The catch is that Mario can only pay for the hats tomorrow after he has sold them at his event. Claudio agrees and hands over the hats to Mario.
Claudio stays at the beach and sells the remainder of his souvenirs and goes home at the end of the day.
Reconciling His Day
That evening, Claudio counts his cash in-hand and it comes to €700. He deducts his initial investment of €100 used to purchase the hats, leaving him with a profit of €600.
Is this correct? The answer is… it depends.
It depends on whether Claudio is utilizing Cash Accounting or Accrual Accounting. The key factor lies in the timing of when sales and purchases are recorded in the account.
Let’s run through Claudio’s day using each of these methods to see how they differ.
Claudio’s Day using Cash Accounting
Claudio’s revenue consists of 20 hats and 100 plates he sold at the beach. The 30 hats he gave to Mario are not accounted for because he didn’t receive payment for the hats.
Only the €100 for the hats is recorded because the plates were acquired using credit; he hasn’t paid for them yet.
This provides Claudio with a profit result that equals the amount of cash in his pocket. Only transactions that have an impact on Claudio’s cash in-hand are considered.
It should be obvious the problem with this form of accounting in this scenario. This fails to provide a complete picture of what happened throughout the day.
In reality, Claudio sold all of his inventory, but we don’t see the full revenue in the income statement.
Another problem is that we show the revenue for the 100 plates, but no corresponding cost of the goods sold.
In other words, the costs don’t follow the revenue which can provide a misleading picture of the company’s profitability.
Claudio’s Day using Accrual Accounting
With this method, revenue is considered when earned. That statement can lead to a length explanation, so let’s distill it down to its essence.
Revenue is earned when the products were delivered to the customer or services were provided. It’s reasonable to assume that cash for these products and/or services will be received from the customer.
The recognition of expenses follows the Matching Principle; expenses are reported on income statements in the period in which the related revenue is earned. This also requires a liability to appear on the balance sheet for the end of the accounting period.
Claudio’s revenue will include all products sold during the day. This includes the 30 hats he sold to Mario but has yet received cash for.
The 30 hats are recorded because he fulfilled his part of the deal. Claudio also assumes Mario will pay for the hats when promised due to their mutual derived trust.
With this method, Claudio’s revenue is €300 higher than when calculated using Cash Accounting.
By applying the Matching Principle, the expenses should be recognized in the same period as the revenues they helped to generate.
We need to report the Cost of Goods sold for the entire revenue which results in a Cost of Goods equal to -€200.
Claudio’s Net Profit
The Income Statement reports Revenue at €1,000, Expenses at -€200, and a Net Profit of €800 for the day.
This is a very different perspective than the one given when using Cash Accounting.
Balance Sheet Considerations
Additionally, in the Balance Sheet, we would need to report Account Receivable (the €300 Mario owes Claudio) and Accounts Payable (the €100 Claudio owes the manufacturer of the decorative plates.)
Advantages and Disadvantages of Each Method
Cash Accounting – Advantages
- Provides an accurate picture of how much cash a business has
- Simple to apply
- Taxation is not incurred until the cash is received and the cash in in the bank
Cash Accounting – Disadvantages
- Fails to provide a complete picture of the financial situation
- Information of outstanding payments is missing
Accrual Accounting – Advantages
- Provides a more accurate picture of the business
- This is the accepted method of reporting when using GAAP or IFRS (the standards that govern financial reporting and accounting from country to country)
Accrual Accounting – Disadvantages
- More complex than Cash Accounting
- Does not track cash flow; reported income and cash are two separate things
- The Income Statement/Balance Sheet need to be considered along with the Cash Flow Statement to determine if the business is able to generate cash, the “life blood” of any business
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