Cash and Accrual Accounting Definition
There are two main accounting methods used by professionals; accrual and cash methods. Cash method is common with individuals. The difference between the two methods is in the time period through which expenditure and revenue are attributed. In most cases, companies will have a tax year that starts from January 1 to December 31 while others will choose a different period that fits their operations to match with the government tax year.
Accrual accounting involves recording expenses and earnings as they occur while cash accounting only records those expenses and earnings that have been paid.
A Little More on What is the Cash/Accrual Accounting Systems
Accrual and Cash accounting differ in the timing of expenses and income. The cash method will only record income received and expenses that have already been paid for. For instance, an invoice that has been paid is recorded in cash accounting. On the other hand, the accrual method recognizes revenue as soon as it is accrued. This means that company records revenue earned even before the customer pays for it and records expenses when they occur even if they have not been paid for.
The choice of accounting method chosen determines the tax bracket a company falls. Suppose your business has the following:
- A $4,000 invoice received for work done by a consultant
- $100 paid as electricity bill
- A $10,000 invoice sent for services offered that month
- $100 received as return on investment
In cash accounting, your revenue that month would be $0 (subtract received returns from paid bill). In accrual accounting, your profit that month would be $6,000 ((10000 + 100) – (4000 + 100).
While there are businesses that use the cash accounting method, Generally Accepted Accounting Principles recommend the accrual method. You can tell the accounting method a company uses by looking at its financial statements. For instance, the balance sheet of a company using accrual method will show prepaid expenses, accounts receivable and accounts payable and deferred income among others. In cash accounting, a balance sheet will not show all those details besides cash and owner’s capital.
References for Cash and Accrual Accounting
Academic Research on Cash and Accrual Accounting
- The effect of accounting procedure changes on CEOs’ cash salary and bonus compensation, Healy, P. M., Kang, S. H., & Palepu, K. G. (1987). Journal of Accounting and Economics, 9(1), 7-34. This paper looks at how changes in accounting procedures affect cash salary and bonus to CEOs. The paper estimates that there is a relation between corporate earnings and compensation. It concludes that salary and bonuses are not under original accounting method but under reported earnings. It also shows that the effects of compensation changes are small compared to effects that may be experience in the event of industry-wide changes in compensation.
The effects of debt contracting on voluntary accounting method changes, Beatty, A., & Weber, J. (2003). The Accounting Review, 78(1), 119-142. This study examines the effects of a bank’s debt contracts on accounting methods. The study looks at a sample of firms with bank loans and who have changed their accounting methods. It looks at whether the change in accounting method by the firms increased the income of borrowers. It also examines whether the change affects bank contracts, whether there is an expected cost of violating debt contracts and whether banks have restrictions on accounting method changes. The study concludes that, firms that make accounting changes increasing rather than decreasing income. It also concludes that banks incentives to lower interest rates on loans based on performance influence firms to change their accounting methods.
Positive accounting theory: a ten year perspective, Watts, R. L., & Zimmerman, J. L. (1990). Accounting review, 131-156. This study examines positive accounting literature. Specifically, it looks at a publication done in 1978 and 1979 by Watts and Zimmerman. This paper was responsible for the development of positive accounting literature and suggests that contracting costs are important. It also leads to the discovery of certain empirical regularities. It further tries to remove some common misconceptions about accounting methodologies and offers ways to improve research in accounting.
The effect of bonus schemes on accounting decisions, Healy, P. M. (1985). Journal of accounting and economics, 7(1-3), 85-107. This study looks at how executives choose accounting methods that improved their compensation. This paper improves on other research papers that have examined this issue. It does so by analyzing bonus contracts to provide a more detailed account of the incentives these executives get when they choose on accounting method over the other. The paper concludes that, accrual policies adopted by managers are linked to income reporting incentives and changes in methods of accounting procedures are related to changes in managers’ bonus plans.
From cash to accrual budgeting and accounting in the public sector: The Dutch experience, Peter Van Der Hoek, M. (2005). Public Budgeting & Finance, 25(1), 32-45. This paper examines the changes in the public sector accounting methodology and how these changes have enhanced efficiency and effectiveness in government operations. It shows that most countries have already shifted or are planning to shift from the conventional cash based accounting to accrual accounting. The shift is linked to better and wider financial management systems.
The usefulness of accounting estimates for predicting cash flows and earnings, Lev, B., Li, S., & Sougiannis, T. (2010). Review of Accounting Studies, 15(4), 779-807. This paper examines the usefulness of estimates in accounting. However, it notes that the quality of financial information is made unreliable by the difficulties experienced in making reliable estimates. The issue of estimates in accounting is one of the most fundamental. The study analyzes how estimates contribute to the quality of accounting information in accrual accounting. It concludes that estimates enhance forecasting of nest-year earnings and that estimates can be used by investors.
Discounted cash flow: accounting for uncertainty, French, N., & Gabrielli, L. (2005). Journal of Property Investment & Finance, 23(1), 75-89. This paper looks at the repercussions of introducing uncertainty in inputs to produce a wide range of accounting answers. It looks at the risks and benefits of applying different models when estimating in accounting.
The incremental information content of accrual versus cash flows, Bowen, R. M., Burgstahler, D., & Daley, L. A. (1987). Accounting Review, 723-747. This paper looks at the differences that may be seen between the content on accrual accounting reports and the cash flows of a business. With accrual accounting recording money mot received and expenses not paid for, the cash flow statement of a business may differ from other statements. This will have tax repercussions on a business.
Cash versus accrual accounting in public sector, Tiron Tudor, A., & Mutiu, A. (2012). This paper looks at the conventional accounting methods used in the public sector and their limitations. It shows that there have been discussions to shift to the accrual system for better management of finances. It analyzes the movement from the cash based system to the accrual system and how some countries are resisting the move. Romania is one of the countries that has not shifted to the accrual system and which is still doubtful of the new system.
Value of cash holdings and accounting conservatism, Louis, H., Sun, A. X., & Urcan, O. (2012). Contemporary Accounting Research, 29(4), 1249-1271. This study looks at the accounting conservatism and how it mitigates value destruction that comes with cash holdings. It suggests that conservative accounting can reduce agencies problems.
Wall Street’s contribution to management accounting: the Stern Stewart EVA® financial management system, O’Hanlon, J., & Peasnell, K. (1998). Management Accounting Research, 9(4), 421-444. This paper looks at the contributions that Wall Street has made to management accounting. It analyzes EVA financial management system that is geared towards enhancing value maximizing behavior in business management. The EVA system is concerned with the use of residual income in business and the shift towards GAAP-based accounting.