Categorizing accounting practices, it can be sstated that there a two recognized systems, which mainly differ in the way a company records revenues and expenses. The two systems are titled, accrual-basis accounting and cash-basis accounting. The main difference between the two systems can be seen through the time the revenues and expenses are recognized and recorded, i.e. at the time when the transaction took place or at the time when the payment for the transaction was received.
Differentiating those methods according to the types of businesses it can be stated that most for-profit organizations use accrual-basis accounting, while organizations that depend on donations use cash basis to recognize revenues and expenses. In that regard, the present paper will provide an overview of both accounting systems, stating that despite the fact that both methods are suitable for recording transactions, there are differences between both systems, a fact that makes the selection of a suitable bookkeeping method an important decision for companies.
The difference between an actual payment and a legal obligation for such payment is an important element of accrual accounting. As it is often in business there is a period between the creation of legal rights and obligations and the transfer of cash. Thus, such a fact leads to the need for accountants to scrutinize the revenue and expense accounts to make sure amounts due and payable are accrued.
The main task of an accountant in accrual accounting is to verify that revenues and expenses are attributable to the accounting period. Recording only the amounts actually paid during a period might not be sufficient in many cases, as it might lead to that at the end of the period, these accounts might be understated or overstated. Accordingly, for situations in which there might be income from sources other than sales revenue, which must be recognized into the year’s income. In such cases, the accrual-basis method can be a useful tool for accountants.
Accrual accounting has a few disadvantages. The most important of such disadvantages can be seen in measuring the income more accurately than in cash accounting. Such a statement can be explained through the fact that it makes the information of transactions updated more frequently, and thus, it makes it easier to predict future income and finances based on such information. The main disadvantage of accrual accounting, on the other hand, might be seen through the confusion that might result from the fact that net income does not constitute the change in cash during the period. A possible decrease in cash, even of companies with high income is another disadvantage of accrual accounting. In that regard, such disadvantages might contribute to situations when companies might experience cash shortages (Business Book Mall, 2006).
The cash accounting method, as the title implies, focuses on cash, namely on the time of its payment and receipt by an organization. Such a method can be seen as more practical, having its own advantages and disadvantages. The main disadvantage can be seen through offering a misleading picture of long-term profitability. Under this method, the organization’s accounts might show one month to be spectacularly profitable, a fact that in reality might be attributable to the receipt of payments that were in that month, while generally reporting low sales. The cash-basis accounting is largely easy to track, where the main objective is to keep records of cash movement.
The main disadvantage of the cash method is the difficulty to match the expense with the revenue it generates. In this case, income statements and balance sheets might not be able to show a clear picture of recent business activity and present business conditions (Business Book Mall, 2006).
In terms of entries, accrual and cash methods have their own way of recording transactions. Selecting the cash method implies focusing on such elements as receivables, payables, payroll, and inventory. Cash accounting is ideally suited for organizations that do not buy or sell on credit, as it does not recognize cash transactions. All bills, sales, and purchases are recorded in the books when there is the movement of payments to or from the organization.
The cash method does not include entries on account receivables, accounts payables, and even inventory. The complications with such a method might include cases when books might show a large amount of stock that does not exist. The latter understates or overstates the profits of the company. Additionally, depreciation is not recorded in cash-basis accounting, as depreciation is a non-cash item. It should be noted that cash-basis income can be converted to accrual-basis income by simply adding or subtracting the various changes in inventories, accounts receivables, and other non-cash transactions which are directly related to the profitability of the business (Fishman, 2008).
The importance of using accrual accounting can be seen in that it allows keeping a complete general ledger that includes accounts for receivables, payables, inventory, and payroll taxes. Accordingly, the accrual method is the most frequently used by the majority of companies because it provides a more detailed account of the company’s revenue and expenses. Nevertheless, it should be stated that maintaining accrual records requires a professionally trained accountant.
Recording income using accrual accounting is usually reported in the month when the income was earned, even if cash was not received. As for expenses, they are recorded when the organization receives the product, even though it has not paid for it. It should be noted that accrual accounting requires the use of additional balance sheet codes, rather than just cash and net assets. Taking the payment of car insurance, posted in accrual accounting as an example, the entry would imply such using such codes as debit prepaid insurance and credit cash.
When switching to accrual-basis accounting from cash-basis, the organization might report high profits recognizing the expenses accrued and the sales made without cash received. Accordingly, as will be explained in the following paragraph, tax year also has its impact on the accounting method a company might use. Additionally, the accrual method can be used in deferrals – a situation where cash is received or paid for but not reflected in the income statement. In that regard, it can be seen that the accrual system has its own set of advantages, which makes it widely used by most companies.
The accrual method records transaction, regardless of the time of payment, while the cash method records the transaction when the company actually receives the cash for the goods and services rendered. The differences between the two methods become clearer during financial statements preparation. It should be mentioned that the internal revenue service requires that all businesses use the accrual accounting system for filing tax returns. Additionally, it should be noted that if the business has an inventory that is carried over at the end of the month of the year, and if credit is provided, then such an organization should not use cash method accounting (Henson, 2008).
The purpose underlying the accountant’s effort to identify and correctly measure the revenues of an accounting period is to attempt to match them. Matching revenues with their accounting period is important when measuring the ‘financial efforts’ of the company. Such a factor is important when measuring the ‘financial effort’ of earning the revenues of such period. The accountant’s concern is always focused on financial efficiency, which is paralleled with income.
The matching of expenses and revenues is far more complicated than it might appear at first sight. The realization convention permits accountants to recognize financial results only in the form of sales revenues. Considering that there is a time lag between buying or manufacturing goods for sale and selling those goods, there will always be goods awaiting sale and raw materials unused at the end of the accounting period.
The expenses attributable to unsold goods and unused materials, usually described as inventories, must be excluded from the expenses of the period and carried forward to the next accounting period. The importance of inventory adjustments to the correct measurement of periodic income is crucial. The main aspects of such a problem can be seen in the following points:
- How to measure the expenses relating to inventories, that is, what is the correct way to ‘value’ inventories.
- How to effect the adjustment in the accounts, this is the problem with which we shall deal now.
Considering the differences attributable to each accounting method, it can be stated that both of them can be selected based on preferences and certain organizational and financial criteria. Identifying a preference for a particular method, it can be stated that the size of the business can be a determinant factor in that matter. When a company wants to better control tax expenses, a typical situation for small businesses, the cash method might be preferable.
Due to the fact that the accrual-basis method implies recognizing taxes, regardless of the time when benefit was received, companies might pay taxes for revenues which were not received yet. Similarly, many firms might utilize cash-basis accounting in buying materials to be used in the following periods, reducing the revenues of the present year, and accordingly delaying taxes. At the same time, many accountants might implement a hybrid method of accounting, adjusting for a cash basis taxes at the end of the year.
The present paper provided an overview of the accrual-basis and cash-basis accounting methods. The paper outlined the main differences of the methods, providing an analysis of the cases it is used, the main advantages and disadvantages and the transaction procedures. It can be concluded that despite similarities, there are specific cases when a certain method is preferable to be used. Small business can get started by using the cash method while large companies usually should use the accrual method to have a better understanding of their financial status. Generally, accrual accounting systems give an accurate representation of the financial position of the company, while cash systems deals with the cash inflow and outflow. Nevertheless, both systems might be utilized, either separately or combined.
Business Book Mall. (2006). Cash versus Accrual Accounting. Business Book Mall. Web.
Fishman, S. (2008). Cash vs. Accrual Accounting. Web.
Money Instructor. (2002). Accrual Accounting and Adjusting Entries. Money Instructor. Web.