Accrual Accounting vs. Cash Basis Accounting

What is Accrual Accounting vs. Cash Basis Accounting?

Accrual accounting is when transactions are recorded by a company when they are incurred. Cash basis accounting records transactions only when cash changes hands. Accrual accounting provides a more accurate financial picture as it records transactions when they are incurred, rather than when they are paid for. However, both have their uses when analyzing a company’s operations.

Cash Basis Accounting

What is Cash Basis Accounting?

Cash basis accounting is a method where income and expenses are recorded only when cash is received or paid. It is a simple method of accounting and is typically used for small businesses.

Examples of Cash Basis Method

Here are some examples of how the cash basis method would record different types of sales and expenses:

1. Rent Payment: if a company pays two years’ rent in advance, the full amount would be recorded as an expense as soon as it is paid, rather than spreading it over the two years.
2. Electricity Expenses: the expense is recorded only when the electricity bill is paid, not when the electricity is used.
3. Sales on Credit: sales are recorded only when cash is received from the customer, not when the sale is made.

Benefits of Cash Accounting

The key benefit of cash accounting is its simplicity, accounts are easier to understand and implement. There is an immediate recognition of business activity, transactions are recorded when cash is exchanged, providing a clear picture of cash flow.

Downsides of Cash Accounting

However, cash basis accounting also has its disadvantages, and it may provide an incomplete picture of company operations. It also does not account for receivables and payables, which can misrepresent the financial health of a business. It is not GAAP compliant, Generally Accepted Accounting Principles (GAAP) do not recognize cash basis accounting for larger businesses.

Accrual Accounting

What is Accrual Basis Accounting?

Accrual basis accounting records income and expenses when they are incurred, regardless of when cash is exchanged. The means that a company may record a sale (or an expense) before it has actually been paid (or receives payment), but the transaction has been recorded at the time it has taken place.

Examples of Accrual Method

These are examples of when the accrual method is used:

1. Rent Payment: if a company pays two years’ rent in advance, the expense is recognized monthly over the two years in the income statement, rather than all at once when the cash is paid.
2. Electricity Expenses: a company incurs electricity expenses as it uses electricity, so it needs to recognize an accrual (an estimate of the expense) in the income statement every month. The actual expense and liability are corrected when the bill is received, and the expense appears in the cash flow statement when the bill is paid.
3. Sales on Credit: if a company makes sales to customers on credit, the sale appears in the income statement as soon as the sale is made, regardless of when the cash is received. The cash flow statement shows the cash inflow only when the cash is actually received from the customer.

Benefits of Accrual Accounting

The main benefit of accrual accounting is that it provides a more accurate representation of a company’s financial health by including receivables and payables. It is also GAAP compliant and is required by GAAP for larger businesses.

Downsides of Accrual Accounting

There are downsides to accrual accounting which relate largely to keeping a clear picture of the cash flow. It can create more complexity as it can be harder to implement and maintain. It can also be challenging for cash flow management as it does not provide a clear picture of cash flow.

Hybrid Methods of Accounting

Hybrid methods of accounting combine elements of both cash and accrual accounting, allowing businesses to customize their accounting methods to suit their needs. This approach can provide the benefits of both methods while mitigating some of their downsides.

Examples of Hybrid Methods

• Revenue Recognition: a business might use cash-based accounting for recognizing revenue but use accrual-basis accounting for expenses
• Expense Recognition: conversely, a business might use accrual basis accounting for recognizing revenue but use cash basis accounting for expenses

Benefits of Hybrid Methods

The key benefit of a hybrid methos is that it can assist with simplified record-keeping as it is using cash basis method for certain transactions. It is useful as it provides more accurate financial reporting by using accrual basis for other transactions.

Downsides of Hybrid Methods

The main downside is that it may be more complex to implement and maintain compared to using a single method. It may also not be compliant with certain accounting standards or regulations, so companies may have to use an additional accounting method to remain compliant.

Cash vs. Accrual vs. Hybrid Accounting

Here is a summary table comparing the three accounting methodologies:

Accrual Accounting Example

Imagine a company pays two years’ head office rent in advance, so two years’ worth of rent say that amounts to $240,000 comes out of the bank account in one go. If the cash basis of accounting were used, this $240,000 would go into the income statement as an expense as soon as it is paid.

However, that does not reflect the reality of this expense. The reality is that the amount paid relates to an expense that covers a two-year period. Under accrual accounting, the expense is recognized as it is incurred every month. As the company uses the building, one month of rent expense is incurred and only that part is recognized in the income statement as an expense.

So, if we were to look at the income statement for the first six months of the year, only $60,000 would appear as a rent expense. That is the monthly rent of $10,000.

So, the 240,000 is divided by 24 months, and them multiplied by 6. If we contrast this to what happens in the cashflow statement, the full amount of $240,000 will be a cash outflow and incorporated into the cashflow statement as soon as it is paid. That’s because the cashflow statement works on a cash basis.

Download the free accrual vs. cash basis accounting workout for a further example of this.

Is Accrual Basis Accounting Flawed?

Accrual basis accounting is not inherently flawed, but it does have some downsides. Here are some key points:

• Accurate Financial Picture: accrual accounting provides a more accurate representation of a company’s financial health by including receivables and payables
• GAAP Compliant: it is required by Generally Accepted Accounting Principles (GAAP) for larger businesses
• Complexity: accrual accounting is more complex to implement and maintain compared to cash basis accounting
• Cash Flow Management: it can be challenging as it does not provide a clear picture of cash flow

While accrual basis accounting offers a more accurate financial picture and is GAAP compliant, it is also more complex and can make cash flow management challenging. The choice between accrual and cash based accounting depends on the size and needs of the business, as well as regulatory requirements.

Conclusion

Understanding the differences between accrual accounting and cash basis accounting is crucial for businesses to make informed financial decisions. Accrual accounting offers a more accurate and comprehensive view of a company’s financial health by including receivables and payables, making it essential for larger businesses and GAAP compliance.

On the other hand, cash basis accounting is simpler and provides a clear picture of cash flow, but it may misrepresent the financial health of a business by not accounting for receivables and payables. Choosing the right accounting method depends on the size and needs of the business, as well as regulatory requirements.

Additional Resources

Revenue Recognition

Cash Flow Statement

Income Statement