Cash and Accrual Basis Accounting Explained

A lot of the confusion in formal accounting comes from the difference between accrual basis accounting, and cash basis accounting.

Under the accrual basis accounting, revenues are reported on the income statement when they are earned. Under the cash basis accounting, revenues are reported on the income statement when cash is received.

As for expenses, accrual basis accounting matches expenses with the related revenues when the expense occurs. And in cash accouting? You guessed it – expenses are booked when the cash is paid.

The reasoning behind accrual accounting is that it creates an a more realistic income statement (in terms of profitability) during a specific time period. Of course, cash is always KING, and you’ll die without it. But with the income statement we’re looking at a company’s ability to earn a profit.

Here’s an example:

I start a lawn care service in May and provide $1,000 of lawn care services in May, but I don’t get paid until I bill in June. And let’s just say for argument I go on vacation in June and provide no services. There will be a difference in the income statements for May and June under the accrual and cash bases of accounting.

Under the accrual basis, my income statements will show $1,000 of revenues in May and $0 in June. Under the cash basis, it’s just the opposite because cash basis is concerned with when I receive funds, not when I perform services. My May income statement will show no revenues, and I’d have $1,000 in June.

The balance sheet is also affected. Under accrual basis, the May balance sheet will shoe accounts receivable of $1,000, but under cash basis the $1,000 of accounts receivable will not be reported as an asset until June. And really, under cash accounting you don’t have a need for accounts receivable.

To extend the example to expenses assume that I buy mower gas for my lawn care service business in bulk. Under accrual basis accounting, I would create an asset for the entire amount of fuel when I purchase it and expense it out over time as I perform services. This matches the expense to the revenue. Under cash basis accounting, I would expense the entire amount of gas when I purchased it.

The accrual method must be used to match revenues and expenses for financial statements prepared in accordance with Generally Accepted Accounting Principles (GAAP). However, most small businesses can choose whichever method suits their business (and record keeping!) best.

Image Credit: happyeclair, Flickr