- Differentiate between accrual basis and cash basis of accounting
Many small businesses use cash basis accounting. It’s simpler and it mimics the way people handle their personal finances. But as a business grows, it often becomes necessary to switch to accrual basis accounting. Investors, lenders, and government agencies often expect to see financial statements prepared with accrual accounting. GAAP require accrual accounting because it presents a more accurate picture of a company’s financial condition.
| Cash Basis | Accrual Basis | |
|---|---|---|
| Description | Revenue is recorded when payment is received and expenses are recorded when payment is made. | Revenue is recorded when it is earned and expenses are recorded when they are incurred, regardless of when payment is received. |
| GAAP | Not allowed | Required by FASB Statement of Financial Accounting Concepts No. 5: Recognition and Measurement in Financial Statements of Business Enterprises (December 1984) |
| Advantages | Generally easier for smaller entities and for entities that conduct business primarily in cash as opposed to credit. | Provides more information regarding revenue and expenses as well as amounts customers owe and amounts owed to vendors and other creditors. |
| Taxes | Generally, cash basis reporting is permitted for sole proprietors and certain other small businesses. | Generally, accrual basis of reporting for income tax purposes is required for bigger businesses and corporations. |
Let’s take a look at an example of cash basis versus accrual basis in a small business.
Luis’s Landscaping
Let’s say Luis starts a landscaping business in Florida on December 1. He opens a business bank account with $100. He mows 40 yards during the month at $50 each, leaving an invoice (bill) on the door of each customer asking them to pay within 30 days. He earned $2,000, but no one has paid him by December 31 (everyone pays in January). In addition, he had two people working for him and he promised to pay them $300 each as soon as he gets paid (in January), so he incurred $600 in labor expenses, and he put $200 of gas and oil and supplies on his professional account at a local machine shop that he will also pay in January.
On December 31, at midnight, as the fireworks are going off, a friend asks Luis how his new business is going, and he says, “Great!” She asks Luis if he is making any money, and he says, “Tons.”
She presses him for a more specific answer. “How much did you make in December?”
As his accountant, what do you think should be his honest answer?
If he looks at his bank account, it still shows a balance of $100. Cash basis, he made nothing.
But, if Luis thinks about what he earned, minus his expenses (costs of doing business), he could say that he made $2,000. That would be his “gross” earnings. The best answer is that Luis made $1,200. That’s the gross billings of $2,000 (40 yards at $50 each) minus labor costs of $600 minus supplies of $200. His net income is then $1,200.
In January, if he did no other work, just collected his revenue and paid his bills, Luis would have $1,300 in the bank—his original $100 and the $1,200 leftover after he collected his revenue and paid his bills.
Under the accrual basis we record:
| December | January |
| $2000 revenue | $2,000 receipts |
| $800 expenses | $800 disbursements |
Under the cash basis we record:
| December | January |
| $2,000 receipts/revenue | |
| $800 disbursements/expenses |
So, if Luis is at a party on December 31, he is completely correct to say he made $1,200 in December, even if he doesn’t yet have the cash in hand, just as he would say if he worked for an employer who paid him on January 5 for the work he did in December (and presumably paid him on December 5 for work he did in November).
Cash and Accrual Review
If you’d like to go over this concept again, take a look at another lawn mowing business here:
You can view the transcript for “Cash and Accrual – Conceptual” here (opens in new window).
The real difference between accrual basis accounting and cash basis is the timing of revenues and expenses, meaning that the time period for which we are reporting becomes extremely relevant. Imagine if Ford Motor Company, which was found back on June 16, 1903, tried to create an income statement for the whole time it had been in business. Not only would the income statement be kind of a mess, but it also wouldn’t really be relevant for current decision making.
Time Period Constraints
Most businesses exist for long periods of time, and we report the results of business activities using selected time periods. For instance, for tax purposes, most companies and individuals report revenues and expenses for a one-year period. However, depending on the type of report, the time period may be a day, a month, a year, or even some other odd period. Using discrete time periods and accrual basis accounting raises questions about the timing of expenses. For instance, how should an accountant report the cost of equipment expected to produce revenue over the next 10 years? As an asset? As an expense in the year the equipment is purchased? Ratably over the life of the asset?
All those questions and more that you haven’t even thought of yet will be answered in subsequent modules.