Accrual versus cash basis of accounting

When recording transactions, it is important and necessary to record them in the correct accounting period. To do otherwise would result in a misstatement of assets, liabilities, equity, revenues and expenses. If you recall from the previous chapter, we prepare the income statement first where the profit flows into the statement of change in equity (SoCiE) and the ending retained earnings from the SoCiE to the balance sheet. Given the importance of the profit figure in ensuring that the financial statements represent the true economic reality of the business, it is essential that revenues and expenses are recorded correctly and that the revenue and expense account balances are up to date.

Revenues and expenses can be recorded or recognised on either a cash or an accrual basis.  In cash-basis accounting, expenses and revenue are recorded when cash is paid or received.

By contrast, the accrual basis of accounting records revenue and expenses when the transaction happens, such as before a cash settlement. This is an application of the revenue recognition principle and the expense recognition principle (also known as the matching principle) introduced and discussed in Chapter 2, Section 2.4 of the Accounting and Accountability textbook.

Keep in mind that there are several factors that a business should consider before picking an accounting method. Variables like the size of the business and the industry play a determining role in the way the accounting books should be kept. In addition, think about:

• how complicated the business transactions and processes are
• whether the business has the resources to manage accrual accounting
• whether using a computerised accounting system will make a difference.

The following sections expand on these accounting methods and outline the types of businesses best suited to each one.

The Cash Accounting Method

The cash accounting method is quite simple in its application. In fact, the core concept is similar to that of a personal bank account. Income/Revenues such as salary are recorded only when you are paid. Expenses such as paying your credit card are recorded only when you transfer the money. Recognising transactions after cash changes hands allows a business to track its financial activity in real time and provides the business with a current picture of its current cash flow status.

There are plenty of advantages to using this accounting method. Besides allowing for real-time cash flow management, this method offers several potential tax benefits. In fact, a business can legally lower its tax liability by simply controlling the timing of the cash payments. This method doesn’t come without disadvantages, though. Since cash-basis accounting doesn’t show liabilities (what a business is owing to others), a cash-rich business with a high accounts payable can appear more solvent than it actually is.

Due to its simplicity, the cash accounting method is ideal for small businesses or sole proprietorship (discussed in detail in Chapter 4, but essentially a business owned and controlled by one owner) that don’t sell goods or handle inventory management. Cash accounting tracks the actual money coming in and out of your business. In cash accounting, when a business:

The Accrual Accounting Method

Compared to the cash-basis method, accrual accounting is relatively more complex. Recording income and expenses as the transaction occurs involves the use of accounts payable and accounts receivable and involves accounting for long-term liabilities, such as unearned revenue. Moreover, the accrual method requires monthly bank reconciliation to ensure that the amount in the bank account matches the closing balance.

Unlike cash-basis accounting, payments expected to be received in the future are recognised as present income. This provides a more accurate picture of a business’s financial health and its long-term profitability. The disadvantage of this method is that it doesn’t do a great job of tracking cash flow, which can lead to cash shortages when a business is experiencing a downturn.

Accrual accounting is the preferred method for businesses ranging from e-commerce to manufacturing. If a business uses accrual accounting, it records expenses and sales when they take place, instead of when cash changes hands. This way of accounting shows the amounts a business owes to others (i.e. liabilities – usually in the form of accounts payable) and the amounts owing to the business (i.e. assets – usually in the form of accounts receivable). For example, if you’re a builder and send an invoice for a project you’ve completed, you record the sale in your books even though you haven’t been paid yet.