Cash basis vs. accrual basis
/What is the Cash Basis of Accounting?
Under the cash basis of accounting, revenue is recorded when cash is received from customers, and expenses are recorded when cash is paid to suppliers and employees. It is most commonly used by smaller entities with less complex accounting systems.
What is the Accrual Basis of Accounting?
Under the accrual basis of accounting, revenue is recorded when earned and expenses are recorded when consumed. It is most commonly used by larger entities with more complex accounting systems.
Comparing the Cash Basis and Accrual Basis of Accounting
There are several differences between the cash basis and accrual basis, which are as follows:
Recordation timing. Transactions may be recorded in different time periods. The timing difference between the two methods occurs because revenue recognition is delayed under the cash basis until customer payments arrive at the company. Similarly, the recognition of expenses under the cash basis can be delayed until such time as a supplier invoice is paid.
Impact of fraudulent record keeping. The types of fraudulent recordkeeping that can be used to alter financial results will differ, depending on whether you are using the cash basis or the accrual basis. Under the cash basis, merely delaying the receipt or expenditure of cash is an effective way to alter your reported financial outcomes. Under the accrual basis, fraudulent reporting requires more imaginative methods, such as altering the amount of reserves, delaying cutoff periods, and capitalizing expenditures that should have been reported as expenses.
When aggregated over time, the results of the two methods are approximately the same.
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Examples of Cash Basis and Accrual Basis Differences
To apply these concepts, here are several examples:
Revenue recognition. A company sells $10,000 of green widgets to a customer in March, which pays the invoice in April. Under the cash basis, the seller recognizes the sale in April, when the cash is received. Under the accrual basis, the seller recognizes the sale in March, when it issues the invoice.
Expense recognition. A company buys $500 of office supplies in May, which it pays for in June. Under the cash basis, the buyer recognizes the purchase in June, when it pays the bill. Under the accrual basis, the buyer recognizes the purchase in May, when it receives the supplier's invoice.
Usage of the Cash Basis and Accrual Basis
The cash basis is only available for use if a company has no more than $5 million of sales per year (as per the IRS). It is easiest to account for transactions using the cash basis, since no complex accounting transactions such as accruals and deferrals are needed. Given its ease of use, the cash basis is widely used in small businesses. However, the relatively random timing of cash receipts and expenditures means that reported results can vary between unusually high and low profits. The cash basis is also commonly used by individuals when tracking their personal financial situations.
The accrual basis is used by all larger companies, for several reasons. First, its use is required for tax reporting when sales exceed $5 million. Also, a company's financial statements can only be audited if they have been prepared using the accrual basis. In addition, the financial results of a business under the accrual basis are more likely to match revenues and expenses in the same reporting period, so that the true profitability of an organization can be discerned. However, unless a statement of cash flows is included in the financial statements, this approach does not reveal the ability of a business to generate cash.