Accrual Accounting vs. Cash Basis Accounting: What’s the Difference?

Accrual Accounting vs. Cash Basis Accounting: An Overview

The main difference between accrual and cash basis accounting lies in the timing of when revenue and expenses are recognized. The cash method provides an immediate recognition of revenue and expenses, while the accrual method focuses on anticipated revenue and expenses.

Accrual Accounting

Accrual accounting is a method that records revenue when it is earned, meaning when a product or service has been delivered to a customer and there is a reasonable expectation of payment. This approach follows the principle that financial events should be recognized in the period in which they occur, regardless of when payment is received.

In this system, revenue is not dependent on the timing of cash transactions. Instead, it is recorded once the earning process is complete and the business has fulfilled its obligations to the customer. This method is especially important for companies that provide goods or services on credit or have long-term contracts, as it ensures that income is matched with the time period in which it was actually earned.

Likewise, expenses are recorded when they are incurred, not when they are paid. If a business receives goods or services in a given period, the associated expense is recognized during that same period, even if the company doesn’t make the payment right away. This matching of expenses with the revenues is at the heart of accrual accounting.

Cash Basis Accounting

In cash basis accounting, revenue is recorded only when cash is actually received. A business recognizes income at the moment payment is collected, regardless of when the product or service was delivered. This approach is an easier way to track money coming into the business and provides no discrepancies between the amount of revenue earned and the amount of cash received.

Expenses are recorded only when they are paid, not when they are incurred. This means a bill does not show in financial records until payment has been made. For example, if a company receives an invoice for services in January but doesn’t pay the bill until February, the expense would show up in February.

This method is often favored for its simplicity and ease of use, especially by small businesses and individuals managing personal finances. It requires minimal tracking of accounts receivable or payable and focuses solely on transactions that affect the actual cash balance. It also follows the logic that revenue isn’t truly “earned” until you’ve received the actual cash from the sale, regardless of what a customer actually owes you.

Key Differences

Timing of Revenue/Expense Recognition

In cash basis accounting, revenue is recognized only when cash is physically received. Accrual accounting recognizes revenue at the point it is earned—typically when a product is delivered or a service is performed—regardless of when payment is made. Similarly, expenses under the cash method are recorded only when the payment is actually made whereas accrual accounting records them when they’ve been incurred.

Complexity

Cash basis accounting is simpler and easier to implement. It does not require complex accounting systems or extensive record-keeping. Accrual accounting is more intricate, requiring more robust systems to track items owed to others or owed to you.

Adherance to the Matching Principle

Accrual accounting adheres to the matching principle, which requires that expenses be matched with the revenues they help generate in the same reporting period. This produces a more accurate depiction of financial performance. Cash accounting does not follow this principle.

Use of Accounts Payable and Accounts Receivable

Accounts receivable and accounts payable are integral to accrual accounting. These accounts help track money owed by customers and money owed to suppliers. These are not used in cash accounting, as transactions are recorded only when cash is exchanged so there’s never any outstanding payments or receivables.

Implications for Long-Term Contracts

For businesses that engage in long-term projects, such as construction or software development, accrual accounting offers superior financial insight. It allows them to recognize portions of revenue and associated expenses as the project progresses. Instead of potentially having to wait years until revenue is collected under cash basis accounting, incremental revenue can be recognized over the life of the long-term contract.

Regulatory Compliance

Regulatory bodies, such as the IRS in the U.S. or the SEC for public companies, often mandate the use of accrual accounting for companies above a certain size or revenue threshold. This requirement stems from the method’s ability to provide a more consistent and transparent financial picture. Cash accounting may be permissible for smaller entities but is typically not accepted for audited financial statements or filings under GAAP or IFRS.

Tax Implications

The method of accounting can significantly affect tax liabilities. Under cash accounting, income is not taxable until it is received, and expenses are not deductible until they are paid. This allows for some flexibility in managing taxable income, as businessowners could theoretically delay when they deposit a check to defer that revenue into the following period.

Recognition of Unearned Revenue

When customers pay in advance for goods or services, accrual accounting records this payment as unearned revenue—a liability—until the service is performed or the product delivered. Under cash accounting, such payments are recorded as revenue immediately. In this case, cash accounting fails to consider that the company still has an obligation to satisfy (i.e. provide the good or service that customer has prepaid for).

Use of Accruals and Deferrals

Accrual accounting incorporates both accruals and deferrals to ensure that revenues and expenses are recorded in the appropriate periods. Accruals include items like unpaid wages or earned interest, while deferrals refer to prepaid expenses and unearned income. Both types of entries are used to record revenues and expenses before the cash transaction has occurred.

Use of Depreciation and Amortization

In accrual accounting, the cost of long-term assets is allocated over their useful lives through depreciation or amortization. This aligns expenses with the periods that benefit from the asset, as the cost of a capital asset is spread over its life as it gets used. Cash accounting typically expenses the entire asset cost at the time of purchase. This can severely distort earnings, as a company may have a gigantic expense one year followed by little to no expense the next.

Special Considerations

The accrual method is the more commonly used method, particularly by publicly traded companies. One reason for the accrual method’s popularity is that it smooths out earnings over time since it accounts for all revenues and expenses as they’re generated.

The cash basis method records these only when cash changes hands and can present more frequently changing views of profitability.

For example, under the cash basis method, retailers would look extremely profitable in Q4 as consumers buy for the holiday season. However, they would look unprofitable in the next year’s Q1 as consumer spending declines following the holiday rush.

Both methods have their advantages and disadvantages. Each provides different views of the financial health of a company. For investors, it’s important to understand the impact of both methods when making investment decisions.

The vast majority of companies that people would potentially invest in will be using accrual-based accounting. However, should you come across a small company using cash-based accounting, it’s definitely something to watch out for.

Accrual Accounting vs. Cash Basis Accounting: Example

Let’s say you own a business that sells machinery. If you sell $5,000 worth of machinery, under the cash method, that amount is not recorded in the books until the customer hands you the money or you receive the check.

Under the accrual method, the $5,000 is recorded as revenue as of the day the sale was made, though you may receive the money a few days, weeks, or even months later.

The same principle applies to expenses. If the company receives an electric bill for $1,700, under the cash method, the amount is not recorded until the company actually pays the bill. However, under the accrual method, the $1,700 is recorded as an expense the day the company receives the bill.

The Bottom Line

Accrual accounting and cash basis accounting are two ways to record financial transactions. They differ in when a transaction is recorded: accrual accounting when money is earned or an expense is incurred, and cash basis accounting when money is received or an expense is paid. Accrual accounting is required by law; however, there are exceptions where cash basis accounting can be used.