Cash-basis versus accrual-basis accounting

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Cash-Basis

Cash-basis accounting is a method of bookkeeping that records financial events based on cash flows and cash position. Revenue is recognized when cash is received and expense is recognized when cash is paid. In cash-basis accounting, revenues and expenses are also called cash receipts and cash payments.

Cash-basis accounting does not record credit transactions, thus its Balance Sheet does not contain payable, receivable, and prepaid expenses accounts. Because its lack of credit based transactions, it is easy to manage. Additionally, cash-basis accounting is not viable for cost accounting in manufacturing operations because expense is not associated with product cost.

Cash-basis accounting fails to meet GAAP requirement because it does not follow the following two principles:

• revenue recognition principle - revenue should be recognized when it is realized (e.g. a credit sell)
• matching principle - revenue should be matched to the expense if possible (e.g. Sales to COGS)

For example, when you pay your rent your landlord would record an income event when you make the payment. The landlord records an expense event when he pays the rental agent their fee for your apartment. It is the accounting method used by most individuals, and by some businesses that have limited payables or receivables or whose income and expense cash flows are closely associated with each other in time.

A simplified Income Statement and Balance Sheet for cash basis accounting will look like the follow:

         Voidvector Corporation
            Income Statement
   For the year ended December 31, 2004

Revenue ............................ $1,000
Expense ............................ $  800
Net income ......................... $  200

         Voidvector Corporation
              Balance Sheet
   For the year ended December 31, 2004

Assets
 Cash .............................. $5,500
  Total assets ..................... $5,500
Liabilities and Stockholders' Equity
 Common stock ...................... $5,500
  Total liabilities and Equity ..... $5,500

Two types of Cash-basis accounting exist: strict cash-basis and modified cash-basis. Strict cash-basis follows the cash flow exactly. Modified cash-basis includes some elements from accrual-basis accounting such as inventory and property capitalization.

Cash-basis accounting is used by small businesses and households. The financial statements for those entities are used by very limited amount of people; therefore, the accuracy is not significant.

Accrual-Basis

Accrual-basis accounting records financial events based on events that change your net worth (the amount owed to you less the amount you owe others). Standard practice is to record and recognize revenues and expenses in the period which they incur. Even though cash is not received or paid in a credit transaction, they are recorded because they are consequential in the future income and cash flow of the company. Accrual-basis is GAAP compliant.

For example, your landlord would record an income event on the day your rent comes due (you owe it to him). He records an expense event when the fee owed to the rental agent comes due for your apartment that month (he owes it to the agent). The details of the actual cash flows and their timing are tracked by bookkeeping.

A simplified Income Statement and Balance Sheet for accrual basis accounting will look like the follow (note the existence of receivable and payable):

         Voidvector Corporation
            Income Statement
   For the year ended December 31, 2004

Revenues ........................... $1,200
Expenses ........................... $  800
Net income ......................... $  400

         Voidvector Corporation
              Balance Sheet
   For the year ended December 31, 2004

Assets
 Cash .............................. $5,500
 Accounts receivable ............... $  200
  Total assets ..................... $5,700
Liabilities and Stockholders' Equity
 Accounts payable .................. $  200
 Common stock ...................... $5,500
  Total liabilities and Equity ..... $5,700

Comparison

Using cash-basis accounting, income and expenses are credited and debited only when cash is received or paid out. But using accrual-basis accounting, receivables are debited and payables are credited (and, for tax purposes, a profit or loss is thereby determined), even though as yet, no cash has been received or paid out. Cash-basis accounting defers all credit transactions to a later date. It is more conservative in that it does not record revenue until cash receipt. In a growing company, this result in a lower income compare to accrual-basis accounting.

On one hand, a small business such as a fruit stand, which buys its inventory daily for cash at a wholesale market, sells the inventory for cash, and throws away what didn't sell, can get an accurate picture of its profits or losses using cash-basis accounting. On the other hand, a remodeling business that gives customers 90 days to pay and that procures materials on account at the lumber yard, must use the accrual method to gain an accurate picture of its financial condition.

The three standard accrual-basis financial statements do not indicate the cash inflows and outflows of a company. The Statement of Cash Flow is created to indicate that information for accrual-basis accounting.

In the past, accrual-basis account is more costly to maintain, because it requires the bookkeeper to record a lot more transactions. With the advent of accounting software, the conversation between the reporting methods is almost trivial.

Method Selection

Companies that have extended or used credit more expansively will use (and in the United States may be required by the Internal Revenue Service to use) the accrual-basis method of accounting. The Securities and Exchange Commission requires that all publicly traded company to follow GAAP, thus all publicly traded company publish their financial statements using accrual-basis method.

Three kind of external recipients should be considered when deciding the reporting method:

• creditors
• stockholders
• IRS

From the perspectives of creditors and stockholders, cash basis accounting is financially inadequate in that it does not allow one to forecast adequately the future income and cash flow of the company. Additionally, because the deferring of credit transactions in cash-basis accounting, incomes and assets are often less than it actually is. This makes the company look less appealing.

For tax purposes, cash basis accounting is highly favored by companies because it defers tax burdens until the cash is received.