Accrual versus cash basis accounting: differences, reasons, and revenue definitions

Finance Management (Discussion Questions)

Explain the difference between the accrual basis of accounting and the cash basis of accounting. What are the major reasons for accrual accounting? How are revenues defined under accrual accounting?

First Student

In the words of Snyder (2008), "the difference between cash and accrual basis accounting has to do with the time frame in which revenues and expenses are recorded and reported." According to the author, revenues when it comes to the cash basis of accounting are recorded on receipt. This could be before or even after the said revenues are earned. On the other hand, revenues as per the accrual accounting approach are recorded once they are earned (Snyder, 2008). This could be before or after the said revenues are received. Next, when it comes to the cash basis of accounting, expenses according to Snyder (2008) are recorded on payment. This could be before or even after they are incurred. On the other hand however, under accrual accounting, expenses according to the author are recorded on being incurred -- which could either be before or after they are paid.

It is important to note that there are a number of reasons for accrual accounting. To begin with, accrual accounting ensures that a specified financial period's charges and income are recorded (in actual terms) as being part of that particular financial period. Accrual accounting also allows for the appropriate disclosure of liabilities and assets. By following the matching principle, accrual accounting also essentially contributes towards the presentation of a true picture of a business entity's sustainability and profitability for any given period.

Revenues on this front according to Norton, Diamond, and Pagach (2006) are basically "defined as inflows or other enhancements of the assets of an entity or settlement of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities…" (p. 254). Expenses on the other hand as the authors point out are "outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities…" (p. 254).

Third Student

The key point of divergence with regard to the accrual basis and cash accounting basis is the timing or point at which some specific transactions are recorded (Fishman, 2013). When it comes to the cash method, income according to Fishman (2013) "is not counted until cash (or a check) is actually received, and expenses are not counted until they are actually paid." On the other hand, income in the case of the accrual method as Fishman (2013) further points out is counted on the occurrence of a sale. Expenses according to the author are in this case counted on the receipt of the goods and services.

Some of the major reasons for accrual accounting include but they are not limited to the need to match revenues with expenses. The utilization of accruals accounting permits businesses to have a more enhanced picture of expenses and income, and by extension, a better picture of profitability.

Revenues for all intents and purposes are the fees a business earns for the provision of services or for the supply of merchandise. Expenses on the other hand are the various costs that a business incurs in an attempt to generate revenues.

Part B

Reflect on what you have learned from this question and include at least 1 reference either peer-reviewed or the text book.

From this exercise, I have learnt that the accrual basis is more appropriate in some instances than the cash basis of accounting. This is more so the case given that financial transactions are in this case recorded when they take place and not necessarily when cash happens to changes hands. This approach facilitates or permits the creation of a flow/basis for the matching principle. According to Goyal (2007), the relevance of the marching principle cannot be overstated when it comes to the ascertainment of the correct income (profit) amount. Warren (2012), who happens to be in agreement with Goyal, caps it all with his assertion that "accrual accounting is a better predictor of the profitability of a company than is net cash flows from operating activities and the cash basis of accounting" (p. 104).

From this exercise, I have also learnt that in comparison to the cash basis of accounting, the accrual method happens to be somewhat more complicated. This is more so the case given that it calls for the utilization of reconciliations as well as journal entries in an attempt to ensure that the recording of financial statements is done properly. It should however be noted that although many businesses make use of the accrual accounting approach, the best method of accounting is largely dependent on such things as the size of a business.