Cash Basis of Accounting Vs Accrual Basis of Accounting

 

Cash Basis of Accounting vs. Accrual Basis of Accounting

We are going to cover another topic that's often a reason for the confusion: Cash and Accrual accounting.

Two very different accounting methods.

We are going to take a look at both and see how each one could affect a business in different ways. We will also see why income and cash can be two very different things.

The difference between these two concepts is in the timing of when revenue and expenses are recorded in your accounts. So just to be clear, over time both systems will get the same results, but at a certain point in time, there may be differences. And that's something that's important to understand, especially when it comes to the analysis of financial statements.

 Let's start with the easier part, cash accounting.

Cash-based accounting is a very intuitive system. It recognizes transactions only when cash is actually exchanged. So revenue is reported on the income statement only when cash is received, and expenses are only recorded when cash leaves your account. So under this method, it doesn't matter in which month you did the work for your client or you sent an invoice to your customer. The only thing that matters is when they actually paid you. Same thing for expenses. Even when you purchase all kinds of stuff on credit for your business, it won't show in your income statement until you pay for it. So this can be your accounting method of choice because, well one, it's intuitive and it's simple to understand. Two is that, as a business owner, cash is the most important topic to be on top of and cash accounting helps you do that. Number three, you might even be able to do your own bookkeeping in Excel. Meaning, it's much cheaper than having to pay for specialized accounting software or for someone to do the bookkeeping for you. Number four, it's an accepted accounting method in most countries, also for tax purposes. The rules vary by country, but generally, cash accounting can be applied if the business stays below a certain revenue threshold or it doesn't maintain a lot of inventory. So it's a great option for small simple and mainly cash-based businesses.

 An accrual accounting system on the other hand is based on when the transaction happens rather than when cash changes hands. In other words, revenue is reported when it's earned and expenses are recorded when they are incurred.

So for example, if your company sells goods in January but isn't paid until February, then the revenue isn't recorded until February under the cash accounting method. But it would be reported in January under the accrual accounting method. Let's better understand the difference between cash and accrual accounting, especially because it seems cash accounting is much easier.

 Why do we even need accrual accounting?

Let's try to answer that. Remember Claudio and his Italian beach business?

Like any other day, Claudio today goes to his trusted manufacturer of tourist souvenirs to buy his supply of plates. This time though, the manufacturer tells Claudio that he wants to optimize his processes and he was to avoid the daily cash transactions. He would like to bring out the cash register only just once per week, and because Claudio has been a great customer for him, he'd be willing to give him credit. So they agree to settle the purchases for the week always on Fridays. For Claudio, this is a great deal, because he doesn't have to pay right away. He's working with somebody else's money. This way we can even expand his souvenir business and buy another item to sell from another manufacturer with his initial 100 euros. In business, we call this the leverage effect. So Claudio decides to go ahead with this idea and invests is 100 euros in another item, and buys 50 hats in cash. He pays two euros for each hat and plans to sell them for 10 euros to the tourists. Now, at the beach, he has 100 plates and 50 hats to sell.

His friend, let's call him Mario, comes along and sees the new hats Claudio is selling and he really likes them. He tells Claudio that he wants to buy 30 hats for this event he's going to in the evening, but he can only pay for them tomorrow after he sold them at the event. Claudio agrees and hands over the 30 hats to Mario. He stays at the beach and sells the rest of his souvenirs and then goes home. He counts the money in his pocket as usual, and it turns out to be 700 euros. He deducts an initial investment of 100 euros that he left the house with, and this gets him to a profit of 600 euros. Is this correct?

The answer is, it depends, It depends if Claudio's applying the cash accounting method or accrual accounting.

 As we've learned, the difference between the two lies in the timing of when sales and purchases are recorded in your accounts.

So let's apply cash accounting to create Claudio's income statement. His revenue consists of the 20 hats and 100 plates he sold at the beach. The 30 hats for Mario are not accounted for because he didn't get paid for it yet. Likewise, for his expenses, only the 100 euros for the hats are recorded, because of the plates, he didn't pay for. Basically, this gives us exactly the profit Claudio is calculating by using his usual method of counting the cash in his pocket. And really, this is what it is. Only transactions that have an impact on cash are considered. And we can already see the problem with that. It doesn't provide a complete picture of what happened during the day. In reality, he sold all of his inventory, but in the income statement, we don't see the full revenue. Another problem is that we show 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 present quite a misleading picture of the company's profitability.

 Now let's take a look at accrual accounting. With this method revenue is considered when earned, but what does that mean exactly?

This can be quite a complicated topic. But in a nutshell, revenue is earned when the products were delivered to the customer or services were provided, and it's reasonable to expect that cash will be received from the customer. The recognition of expenses follows the matching principle, which means that they are recognized in the period in which the related revenue is recognized.

 Let's see how that looks like for Claudio. His revenue will include all products he sold during the day, meaning, also the revenue for the 30 hats he sold to Mario and didn't receive cash for.

 Why? Because he handed over the hats, he fulfilled his part of the deal, and Claudio doesn't have any reason to expect Mario is not going to pay him. Therefore, Claudio's revenue is 300 euros higher than under the cash accounting.

 What about his costs?

By applying the matching principle, the expenses should be recognized in the same period as the revenues they helped to generate. Therefore, we need to report the cost of goods sold for the entire revenue, which results in COGS of 200. This way, the income statement reports revenue of 1,000 and a net profit of 800 for the day. Quite different than what we would report under cash accounting. In addition, in the balance sheet, we would have to report accounts receivable, the 300 Euros Mario still owes Claudio, and accounts payable. The 100 Euros Claudio owes the manufacturer of the plates. Both methods have their advantages and disadvantages.

 The cash accounting method provides an accurate picture of how much cash a business has. It's simple to apply, and since the transactions aren't recorded until the cash is received or paid, the income of the business is not taxed until it's in the bank. On the other hand, it doesn't provide a full picture, and because it doesn't report receivables or payables, it doesn't show outstanding invoices that haven't been paid yet.

The accrual method on the other hand gives a more accurate picture of the business. If the company has to report under GAAP or IFRS, then that's the accepted method. But it means more complex processes in accounting. And its purpose is not to track cash flow. So the key point here is that reported income and cash can be two very different things. Therefore, under accrual accounting, don't just look at the income statement or the balance sheet. Focus on the cash flow statement as well to see if the business is able to generate cash, which is the lifeblood of any business.

 I hope this will helpful for you to get familiar with these two accounting methods

We will look at both methods in detail in the following video lecture: