Back to: ACCOUNTING, TAX, & REPORTING
Cash and Accrual Accounting Definition
Companies and professionals follow one of two different accounting methods:
- The accrual method, and
- The cash method.
Cash Basis Accounting Definition
The cash method is used by individuals. The substantial difference lies in the time period to which costs and revenues are attributed. The US tax period is one year with a pre-determined beginning and end date. Most individuals and companies have a January 1 to December 31 tax year. Some companies choose an alternative tax year to better fit operations.
Accrual Basis Accounting definition
Accrual accounting is a method that recognizes economic events when they occur (rather than when the cash transaction takes place) to measure the performance and the position of a firm.
It allocates the income and expenses according to the period they refer to — regardless of the time the funds are collected or paid. Restated, when a company has a transaction that has not yet been carried out, the operation is accounted for at the time it’s made and not when a movement of money occurs.
The main reason for the accrual principle is to ensure that the company’s accounts portray the patrimony, the financial situation, and the economic results it obtained in that period.
The accrual principle obligates a company to create the income statement every accounting year, which includes the expenses and income of that period.
A Little More on What is the Cash Basis and Accrual Accounting Systems
The basic difference between cash and accrual accounting methods is related to the timing of income and expenses. The cash basis recognizes the income when the money comes in and recognizes the expenses in which the money is paid. The cash basis does not recognize accounts receivable or payable.
For example, only when you pay an invoice is an expense recognized. The accrual principle recognizes income when accrued. That is, the company records the revenue when it is earned, even if the customer has not paid yet. For example, a contractor using the accounting records accrues total income obtained when the work is finished, even if the client has not paid the final invoice. Expenses are handled in the same way. The contractor records expenses when they occur and not when they are paid.
The tax repercussions between employing the cash versus accrual methods of accounting can be extreme. Suppose you have a business with these operations:
- You received an invoice for $ 4,000 for the work done this month by a consultant.
- You paid $ 100 for a telephone bill.
- You sent an invoice for the $ 10,000 for fees of services performed that month.
• You received $ 100 in investment income.
If you were using cash values, your benefit for that month would be US $ 0 (the US $ 100 in income, fees less US $ 100 in telephone bill). If you were using accrued values, your profit would be US $ 6,000 (US $ 10,000 in fees for services minus the US $ 4,000 in consulting expenses).
Generally Accepted Accounting Principles (GAAP) are the standards and conventions used in the US. To achieve uniformity in the financial and accounting statements GAAP favors the accrual method above the cash basis method. Many unincorporated small businesses use the cash accounting method without problems.
While looking at a financial statement or other reports, some clues indicate whether the company employs an accrual method of accounting or cash accounting method. An accrual base balance sheet, for example, will show a number of accounts receivable and payable, deferred income, and prepaid expenses. A cash accounting report will not show any of these accounts, only cash and owner’s capital.
Example of Cash Basis and Accrual Basis of Accounting Principal
A company called ZZ sells a fleet of trucks during December. When recording this transaction under cash accounting method, the sale will be recorded in that year even if the customer decides to pay. Under the accrual method, the sale will be recorded in December, as the buyer incurred the obligation to pay.
Now let’s assume that the company ZZ also hired an advertising agency to carry out a marketing campaign. These services were provided in November 2012, and a corresponding invoice was issued on this same date. The company and the advertising agency signs a contract which establishes that the payment is to be made three months after the invoice was issued, i.e. in February 2013.
The accrual principle ensures that the transactions are accounted for according to the flow of goods and services no matter when the collection or payment is made. So in the above example, keeping in mind that the service was invoiced in 2012, the record of the transaction must be produced in the 2012 financial year and not at the time of payment in February 2013.
References for Accrual Basis and Cash Basis of Accounting Principle
Academic Research on Accrual Basis of Accounting
- Accounting earnings and cash flows as measures of firm performance: The role of accounting accruals, Dechow, P. M. (1994), Journal of accounting and economics, 18(1), 3-42. This paper investigates the circumstances in which the accruals can be predicted to improve the earnings’ ability to measure the firm performance as the stock returns reflect.
- Application of accrual accounting in the Australian public sector–rhetoric or reality, Guthrie, J. (1998), Financial accountability & management, 14(1), 1-19. This article gives a detailed historical analysis of the recent developments of accrual accounting in the Australian Public Sector. It questions the accrual accounting developments on various grounds.
- Cash or Accrual Basis Accounting-Which System is Better for the Law Firm, Frederick, T. C. (1983), Legal Econ., 9, 51. This paper investigates two accounting methods, cash and accrual basis accounting. It attempts to find out which of these methods is better suited to the needs of a law firm.
- Accrual versus cash-basis accounting methods: An agency-theoretic comparison, Kwon, Y. K. (1989), Journal of Accounting and Public Policy, 8(4), 267-281. This paper portrays systematically that accrual accounting is better that cash-basis accounting in an agency setting. It argues that accrual accounting information shows the overall impacts that managerial actions have on future cash flows than in cash flow realizations in any period.
- 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 investigates how governments used to employ cash-based accounting systems together with input-based budgeting systems. It also recognizes how various governments are shifting to accrual-based accounting since the previous methods were proving it hard for them to operate efficiently and effectively.
- Is the move to accrual based accounting a real priority for public sector accounting, Wynne, A. (2007), Public Fund Digest, 6(1), 25-39. This article examines whether the shift to accrual-based accounting if a real option in public sector accounting.
- Financial transparency and corporate governance: you manage what you measure, Lowenstein, L. (1996), Columbia Law Review, 96(5), 1335-1362. This is an essay that acknowledges how corporate financial reporting in the United States is better than anywhere else and why it is contributing excellently to effective corporate governance and oversight.
- Economic incentives and the choice of state government accounting practices, Ingram, R. W. (1984), Journal of Accounting Research, 126-144. This paper generally elaborates on the economic incentives that accompany the choice of state accounting practices.
- Reshaping public sector accounting: an international comparative view, Pina, V., & Torres, L. (2003), Canadian Journal of Administrative Sciences/Revue Canadienne des Sciences de l’Administration, 20(4), 334-350. The purpose of this paper is studying the government accounting transformations that are carried out in the member countries of the Organization for Economic Coordination and Development (OECD) together with the European community. The study intends to take as its benchmark, the International Public Sector Accounting Standards (IPSAS).
- Reporting public sector financial results, Hodges, R., & Mellett, H. (2003), Public Management Review, 5(1), 99-113. This article investigates the use of accrual-based accounting in the public sector. It gives examples sampled from the UK National Health Service of various situations in which the accrual system is seen as unsuitable.
- Earnings quality in UK private firms: comparative loss recognition timeliness, Ball, R., & Shivakumar, L. (2005), Journal of accounting and economics, 39(1), 83-128. This paper involves a hypothesis set to prove that private companies’ financial reporting has a lower quality than that of public companies because of different market demand regardless of the regulations. In support of this hypothesis, the paper has a large UK sample.
- Alternative information sources and information asymmetry reduction: Evidence from small business debt, Cassar, G., Ittner, C. D., & Cavalluzzo, K. S. (2015), Journal of Accounting and Economics, 59(2-3), 242-263. This paper examines if accrual-based accounting interacts with other information sources to ensure the reduction of information asymmetries that arise between small business borrowers and lenders to reduce the borrowers’ probability of loan denial and debt cost.