Cash basis vs accrual basis of accounting – Definition
The cash basis and the accrual basis are the two basic methods of accounting. Each method identifies a different set of rules for recognizing revenues and expenses. The accrual basis of accounting means that revenues, expenses, and other changes in assets, liabilities, and owners’ equity are accounted for in the period in which the economic event takes place, not when the cash inflows and outflows take place. Alternatively, the cash basis of accounting means that revenues and expenses are not recognized until the cash is received or paid.
The Accrual Basis of accounting
As we noted, the best matching of revenues and expenses takes place when the accrual basis of accounting is used. This means that the financial effects of transactions and economic events are recognized by the enterprise when they occur rather than when the actual cash is received or paid by the enterprise. For example, sales are recognized as revenues when they are made, and services are recognized when they are performed, regardless of when the cash from that sale or service is actually collected.
That is, a sale on the account is recognized in the same manner as a cash sale is. The only difference is that Accounts Receivable rather than Cash is increased or debited at the time of sale. When the cash from the sale on the account is collected, no revenue is recognized. The cash collection is just an exchange of one asset, Accounts Receivable, for another asset, Cash. At this point, the total amount of assets remains the same. The revenue and asset increases were recognized at the time the sale took place.
With the accrual basis of accounting, if cash, such as a deposit or a down payment, is received before the actual sale or the performance of a service, no revenue is recognized until the sale is made. Instead, a liability to perform a future service or to deliver a product is recognized at the time the cash is received. This liability is usually referred to as unearned revenue. When the service is finally performed or the sale is made, the revenue is then recognized, and the liability is decreased.
Expenses are recognized in a similar manner. That is, expenses are considered to be incurred or used when the goods or services are consumed by the enterprise, not necessarily when the cash outflow takes place. For example, the Carson corporation records as a June expense the salaries earned by its employees in that month, even though those salaries may not be paid until July. This is accomplished by recording Salaries Payable in June. When June’s salaries are paid in July, no expense is recognized at that time. Both a payable and Cash are reduced at that time, but no expense is involved. The decrease in the firm’s net assets and the corresponding expense were recorded in June.
In many cases, the cash is paid at the same time the expense is incurred, For example, plumbing repairs may be paid when the services are rendered. In this case, Repairs and Maintenance Expense would be recorded when the cash was paid. How. ever, it is not the payment of cash that triggers the recognition of the expense, The expense is recognized because the plumbing services were received by the firm at that time, Finally, using the accrual basis of accounting, if cash is paid before incurring the expense; no expense is recognized at that time. For example, if a firm prepays its June rent in May, the prepayment is considered an asset in May and is not considered expense until June.
The Cash Basis of Accounting
With the cash basis of accounting, a sale is recognized when the cash is collected, and an expense is recognized when the cash is paid. The cash basis of accounting thus does not properly match revenues and expenses. This is because the recognition of revenue and expense is contingent upon the timing of cash receipts and disbursements and, depending on this timing, the expenses of one period could be matched against the sales or services of another period.
The cash basis of accounting, therefore, is not considered a generally accepted accounting principle for financial reporting purposes. However, many professionals, such as doctors and lawyers, who prepare financial statements solely for themselves, use the cash basis in order to simplify their record keeping. In addition, most individuals use the cash basis of accounting in determining their taxable income.
An Example of the Cash versus the Accrual Basis of Accounting
An example of the difference between the accrual and the cash bases of accounting is presented below. This table shows how 10 different transactions for the month of May affect accrual basis and cash basis income. As this table shows, total accrual basis revenue is equal to cash sales made in May, plus all sales made on credt during this period. Total expenses during the period are equal to those incurred and paid in cash during May, plus expenses incurred on credit during the month. Cash basis net income is solely a function of when the cash is received and paid.