Accrual basis versus cash basis accounting principles and differences

Accounting

In just about any part of the world, accrual accounting is preferred by government over cash accounting, for several good reasons. To understand these reasons, the first step is to understand what the difference is between accrual accounting and cash accounting. Cash accounting is a standard form of accounting for very small businesses and for households, where the entire basis of accounting is the cash flows in and out. Under the cash method, income is not counted until the cash is received, and expenses are not recorded until the cash goes out (Fishman, 2013). This principle treats cash flow as the only thing that matters. It is often used by very small businesses because it mirrors their daily reality -- cash is the only thing that really matters.

Accrual accounting is based on a different principle altogether. Accrual accounting is based on the idea that transactions are recorded when they occur, rather than when the cash moves (Shanker, 2013). The timing of the cash flows is not actually all that important in accrual accounting, save for the cash flow statement. For the income statement, it only matters when the transaction occurs (SBA.gov, 2013). The key date is the job completion date -- when a sale is formalized (No author, 2013). So with accrual accounting, the cash might arrive later, but if the sale occurs today, it is recorded today, along with an accounts receivable entry. When the cash arrives, the accounts receivable is reduced and the cash account increased to account for the change in cash position, but the sale at this point has already been recorded.

The difference in how income and expenses are recorded between these two systems is why most tax authorities favor the accrual system. In general, the accrual system delivers a more accurate portrayal of the firm's financial health. The cash system can be distorted because of the timing of the cash flows. For example, if a company makes a sale on December 12th, and gets paid in January, then that would show as a January sale under cash accounting, but a December sale under accrual accounting. The truth is that the sale was made in December, so counting it as a December sale only makes sense.

The same principle works with expenses. Consider for example the purchase of a large vehicle for deliveries. If this purchase is made in late December, but the cash moves in January the two systems will treat the timing differently. In cash accounting, however, there is no way for any outsider to know that the purchase has been made. The company is obligated to pay in January, but there is no record of that on the company's financial statements. Under accrual accounting, there would be such a record, as an accounts payable entry. Consider as well the issue of larger expenses such as mortgages and leases. Or purchases that are to be amortized. Cash accounting will only record the payments of leases, but not the lease obligation itself.

For a purchase that is very large and needs to be amortized, there is a significant difference in the two systems. The cash accounting system would record the entire transaction at once if cash was paid. If the company borrowed that cash, there would be no entry that reflects the loan obligation, nor would there be any entry that reflects the useful life of that asset. The company would record a substantial loss for that quarter based on cash flows, but then have substantial profits in all the other quarters. This again is a distortion of the company's financial picture, and accrual accounting seeks to remedy this issue. Under accrual accounting, the purchase would be amortized, so that the expense only shows a little bit each quarter for the expected useful life of the asset. This would be offset by the periodic revenues generated from the asset. This matching of asset costs and benefits is closer to economic reality for the company, and that is why it is an important part of the accrual accounting system.

As these examples illustrate, the accrual system is much better with respect to dealing with complexity. Accrual accounting is therefore useful for any business that does not operate on a strictly cash basis. Only those businesses that operate on a cash basis should use cash accounting. The minute that there is a misalignment between when a transaction occurs and when the cash flow occurs, the accrual system is better.

Further, the accrual system is differentiated in that it is used by professional organizations, the SEC and it is the only system used for tax purposes. For financial statements this is an important distinction. Neither investors nor regulators will accept cash basis statements, so a company that is producing them is not going to be treated well. It is too easy to manipulate statements using cash accounting simply by making adjustments to the timing of the cash flows. The IRS in particular is not a fan of this, and insists on accrual accounting as a means of ensuring that companies are portraying their financial condition accurately.