Cash Basis Verses Accrual Basis

Cash Basis vs. Accrual Basis

The cash basis of accounting is more likely to be used by service businesses than by retail or manufacturing businesses. Service businesses usually do not need equipment and can sell a service they perform with nothing more than their own hands and minds. Think of people who are lawyers, writers, public relations and advertising personnel, and accountants.. (Edmonds, McNair, Milam, and Olds, Fundamental Financial Accounting Concepts, 4th edition, McGraw-Hill Irwin, 2002) In the cash basis of accounting, the business records are "cash in" (deposits to the bank account) called cash receipts, and "cash out" (checks) called cash disbursements. Cash receipts - Cash disbursement = Cash flow. Each month's cash flow is added to the preceding month's cash balance yielding the current month's cash balance. Unless a business is a small service company, it cannot tell if it is earning a profit if it uses cash accounting. There are two reasons. The first reason is that cash receipts and disbursements related to the same business activity do not always fall in the same month. For example, a lawyer may perform a real estate closing in May, pay for real estate closing photocopies in May, and get paid by the client for the real estate closing in June. The cash disbursement and receipt do not occur in the same month. The second reason is that some cash disbursements are made for assets that provide a gradual benefit to the business over time. Property and equipment are examples.

Accrual accounting is different from cash accounting and measures much more: cash and other assets, owner's equity, cash flow, and profit (usually referred to as income, or net income). Accrual accounting uses four statements to keep track of an enterprise: the balance sheet, the income statement, the statement of cash flows, and the statement of changes in owner's equity (or statement of stockholders' equity). The balance sheet is based on the equation: Assets = Liabilities + Owner's equity. The balance sheet shows the owner's equity on the balance sheet date. The income statement is based on the equation: Revenues - Expenses = Net income or Loss. The income statement shows how much profit (or loss) a business made during a specific period. Accrual accounting matches expenses with the revenue used to create them, so profit can be measured from period to period In short Under the cash method, a business reports income when it is received and reports expenses when cash is disbursed. Under the accrual method, a business reports income when the business has the right to receive the income and reports expenses when all events, which create the liability, have occurred and the amount of the expense is reasonably determinable. The differences between the two systems can be shown in the following example.

AXY FARMS (Cash)

Year ending December 31

RECEIPTS

Cash grain sales

Government program payments

TOTAL CASH RECEIPTS

EXPENSES

Cash operating expenses

Interest paid

TOTAL CASH EXPENSES

Depreciation*

TOTAL EXPENSES

Net farm income from operations (cash basis)

Gain/loss on sale of farm capital assets

Net farm income, before tax (cash basis)

Income taxes & S.S. taxes paid

NET FARM INCOME, AFTER TAX cash basis)

AXY FARMS (Accrual)

Year ending December 31

REVENUES

Cash receipts from grain sales

Change in grain inventory

Government program payments

Change in accounts receivable

GROSS REVENUES

EXPENSES

Cash disbursements for operating expenses

Change in accounts payable

Change in prepaid expenses

Change in unused supplies

Change in investments in growing crops

Depreciation

TOTAL OPERATING EXPENSES

Interest paid

Change in accrued interest

Accrual interest expense

TOTAL EXPENSES

Net farm income from operations

Gain/loss on sale of farm capital assets

Net farm income

Income taxes & S.S. taxes paid

Change in income taxes & S.S. taxes payable

Changes in current portion of deferred taxes

Accrual income taxes & S.S. taxes

NET FRAM INCOME AFTER TAX accrual basis)