Cash and Accrual Method Accounting - Explained
What is Cash and Accrual Accounting?
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Table of ContentsWhat is Cash Basis Accounting?What is Accrual Basis Accounting?What is the difference between Cash Basis and Accrual Accounting Systems?Examples of Cash Basis and Accrual Basis AccountingExample of Cash Basis and Accrual Basis of Accounting Principal
What is Cash Basis Accounting?
The cash method is used by individuals. The substantial difference lies in the time period to which costs and revenues are attributed. The US tax period is one year with a pre-determined beginning and end date. Most individuals and companies have a January 1 to December 31 tax year. Some companies choose an alternative tax year to better fit operations.
What is Accrual Basis Accounting?
Accrual accounting is a method that recognizes economic events when they occur (rather than when the cash transaction takes place) to measure the performance and the position of a firm. It allocates the income and expenses according to the period they refer to -- regardless of the time the funds are collected or paid.
Restated, when a company has a transaction that has not yet been carried out, the operation is accounted for at the time it's made and not when a movement of money occurs. The main reason for the accrual principle is to ensure that the company's accounts portray the patrimony, the financial situation, and the economic results it obtained in that period. The accrual principle obligates a company to create the income statement every accounting year, which includes the expenses and income of that period.
What is the difference between Cash Basis and Accrual Accounting Systems?
The basic difference between cash and accrual accounting methods is related to the timing of income and expenses. The cash basis recognizes the income when the money comes in and recognizes the expenses in which the money is paid. The cash basis does not recognize accounts receivable or payable. For example, only when you pay an invoice is an expense recognized.
The accrual principle recognizes income when accrued. That is, the company records the revenue when it is earned, even if the customer has not paid yet. For example, a contractor using the accounting records accrues total income obtained when the work is finished, even if the client has not paid the final invoice. Expenses are handled in the same way. The contractor records expenses when they occur and not when they are paid. The tax repercussions between employing the cash versus accrual methods of accounting can be extreme.
Examples of Cash Basis and Accrual Basis Accounting
Suppose you have a business with these operations:
- You received an invoice for $ 4,000 for the work done this month by a consultant.
- You paid $ 100 for a telephone bill.
- You sent an invoice for the $ 10,000 for fees of services performed that month. You received $ 100 in investment income.
If you were using cash values, your benefit for that month would be US $ 0 (the US $ 100 in income, fees less US $ 100 in telephone bill). If you were using accrued values, your profit would be US $ 6,000 (US $ 10,000 in fees for services minus the US $ 4,000 in consulting expenses).
Generally Accepted Accounting Principles (GAAP) are the standards and conventions used in the US. To achieve uniformity in the financial and accounting statements GAAP favors the accrual method above the cash basis method. Many unincorporated small businesses use the cash accounting method without problems. While looking at a financial statement or other reports, some clues indicate whether the company employs an accrual method of accounting or cash accounting method. An accrual base balance sheet, for example, will show a number of accounts receivable and payable, deferred income, and prepaid expenses. A cash accounting report will not show any of these accounts, only cash and owner's capital.
Example of Cash Basis and Accrual Basis of Accounting Principal
A company called ZZ sells a fleet of trucks during December. When recording this transaction under cash accounting method, the sale will be recorded in that year even if the customer decides to pay. Under the accrual method, the sale will be recorded in December, as the buyer incurred the obligation to pay. Now let's assume that the company ZZ also hired an advertising agency to carry out a marketing campaign. These services were provided in November 2012, and a corresponding invoice was issued on this same date. The company and the advertising agency signs a contract which establishes that the payment is to be made three months after the invoice was issued, i.e. in February 2013. The accrual principle ensures that the transactions are accounted for according to the flow of goods and services no matter when the collection or payment is made. So in the above example, keeping in mind that the service was invoiced in 2012, the record of the transaction must be produced in the 2012 financial year and not at the time of payment in February 2013.
- What is the Accounting Cycle? – Financial Accounting
- Accrual vs Cash Basis Accounting – Financial Accounting
- What are Accounting Adjustments? – Financial Accounting
- What is an Adjusted Trial Balance – Financial Accounting
- Completing the Accounting Cycle - Creating Financial Statements
- What is the Trial Balance Closing Process – Financial Accounting
- Example of the Closing Process