Cash basis vs. accrual basis
/What is the Cash Basis of Accounting?
The cash basis of accounting is a method where revenues and expenses are recorded only when cash is actually received or paid. Under this approach, income is recognized when payments are collected, and expenses are recognized when they are paid, regardless of when they are incurred. This method is straightforward and often used by small businesses and individuals due to its simplicity and ease of tracking cash flow. However, it can present a misleading picture of financial performance for larger businesses, as it ignores receivables and payables, potentially causing significant timing mismatches between revenue and expenses. Unlike the accrual basis of accounting, the cash basis does not adhere to generally accepted accounting principles (GAAP).
What is the Accrual Basis of Accounting?
The accrual basis of accounting is a method in which revenues and expenses are recorded when they are earned or incurred, regardless of when cash is actually received or paid. This approach provides a more accurate picture of a company's financial performance and position by recognizing economic events in the periods to which they relate. For example, under accrual accounting, a business records revenue when it delivers goods or services to a customer, even if payment is received later. Similarly, expenses are recognized when incurred, not when paid. This method is in contrast to the cash basis of accounting, which records transactions only when cash changes hands, and is required by Generally Accepted Accounting Principles (GAAP) for most medium and large businesses.
Comparing the Cash Basis and Accrual Basis of Accounting
There are several differences between the cash basis and accrual basis, which are as follows:
Recognition of revenue. The cash basis of accounting only recognizes revenue when cash is received, while the accrual basis of accounting only recognizes revenue when it is earned.
Recognition of expenses. The cash basis of accounting only recognizes expenses when cash is paid, while the accrual basis of accounting only recognizes expenses when they are incurred.
Accuracy of financial position. The cash basis of accounting provides a less accurate view of financial health due to timing differences in cash flows, while the accrual basis of accounting offers a more accurate picture by matching revenues and expenses to the appropriate periods.
Complexity level. The cash basis of accounting is simpler to maintain, and so is suitable for small businesses without extensive financial reporting needs. The accrual basis of accounting is more complex and requires adjusting entries and tracking receivables and payables.
Recordation timing. Transactions may be recorded in different time periods. The timing difference between the two methods occurs because revenue recognition is delayed under the cash basis until customer payments arrive at the company. Similarly, the recognition of expenses under the cash basis can be delayed until such time as a supplier invoice is paid.
Impact of fraudulent record keeping. The types of fraudulent recordkeeping that can be used to alter financial results will differ, depending on whether you are using the cash basis or the accrual basis. Under the cash basis, merely delaying the receipt or expenditure of cash is an effective way to alter your reported financial outcomes. Under the accrual basis, fraudulent reporting requires more imaginative methods, such as altering the amount of reserves, delaying cutoff periods, and capitalizing expenditures that should have been reported as expenses.
Compliance requirements. The cash basis of accounting is not compliant with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) for most companies. Conversely, the accrual basis of accounting is required by GAAP and IFRS for medium and large businesses.
Tax implications. The cash basis of accounting is often used by small businesses for tax purposes due to its simplicity and the immediate recognition of cash flows. The accrual basis of accounting may result in higher taxable income if revenues are recognized before cash is received.
Adherence to the matching principle. The cash basis of accounting does not follow the matching principle, leading to potential mismatches of revenues and expenses. Conversely, the accrual basis of accounting does follow the matching principle by aligning expenses with the revenues they generate.
In summary, while the cash basis is simpler and more straightforward, the accrual basis provides a more complete and accurate reflection of a business's financial performance and is required for most larger organizations.
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Examples of Cash Basis and Accrual Basis Differences
To apply these concepts, here are several examples:
Revenue recognition. A company sells $10,000 of green widgets to a customer in March, which pays the invoice in April. Under the cash basis, the seller recognizes the sale in April, when the cash is received. Under the accrual basis, the seller recognizes the sale in March, when it issues the invoice.
Expense recognition. A company buys $500 of office supplies in May, which it pays for in June. Under the cash basis, the buyer recognizes the purchase in June, when it pays the bill. Under the accrual basis, the buyer recognizes the purchase in May, when it receives the supplier's invoice.
Usage of the Cash Basis and Accrual Basis
The cash basis is only available for use if a company has no more than $5 million of sales per year (as per the IRS). It is easiest to account for transactions using the cash basis, since no complex accounting transactions such as accruals and deferrals are needed. Given its ease of use, the cash basis is widely used in small businesses. However, the relatively random timing of cash receipts and expenditures means that reported results can vary between unusually high and low profits. The cash basis is also commonly used by individuals when tracking their personal financial situations.
The accrual basis is used by all larger companies, for several reasons. First, its use is required for tax reporting when sales exceed $5 million. Also, a company's financial statements can only be audited if they have been prepared using the accrual basis. In addition, the financial results of a business under the accrual basis are more likely to match revenues and expenses in the same reporting period, so that the true profitability of an organization can be discerned. However, unless a statement of cash flows is included in the financial statements, this approach does not reveal the ability of a business to generate cash.