What is the difference between accrual basis of accounting and cash basis of accounting?

• Accounting

Understand Accrual Accounting vs. Cash-Basis Accounting

What is Accrual Accounting vs. Cash-Basis Accounting?

Under accrual accounting, revenue is recognized once earned and expenses are recorded post-invoice, whereas cash-basis accounting recognizes revenue/expenses immediately after the actual transfer of cash.

Accrual Accounting Definition (U.S. GAAP)

The difference between accrual and cash basis accounting lies in the timing of revenue and expense recognition – or more specifically, the conditions that are required to be met for revenue or expenses to be recorded.

Under U.S. GAAP, the standardized reporting method is “accrual” accounting.

Accrual accounting records revenues once they are earned – which means the product/service was delivered to the customer and the payment is reasonably expected by the company in return.

Even if the customer pays on credit (i.e. the cash has not yet been received from the customer), the revenue is recorded on the income statement and the amount is captured in the accounts receivable (A/R) line item on the balance sheet.

Regardless of the fact that cash payment was never received, the revenue in such a case would be recognized under accrual accounting.

Likewise, if a company pays a supplier using credit as opposed to cash, the expense is still recorded on the income statement despite the invoice having been not paid off, which reduces the taxable income in the current period.

Even though the company will eventually make the cash payment for the products/services received, the cash is in the possession of the company for the time being and the amount is recorded on the balance sheet as accounts payable (A/P).

Cash-Basis Accounting Definition

In comparison, “cash-basis” accounting recognizes revenue only if cash payment is actually received for the product/service delivered.

Moreover, a company’s expenses are not recognized until an actual cash payment is made (i.e. a real cash outflow).

The benefit of cash basis accounting is that it tracks the amount of cash a company truly has on hand at any given moment.

For that reason, for distressed companies facing a liquidity shortage, cash-basis accounting is used for internal purposes to share with lenders and/or the Bankruptcy Court.

Unlike accrual accounting, the cash basis accounting method recognizes neither accounts receivable (A/R) nor accounts payable (A/P).

Note that cash-basis accounting is used predominantly by private companies.

Accrual Accounting vs. Cash-Basis Accounting

In cash-basis accounting, the main difference is that the cash value shown on the balance sheet represents the actual amount of cash in the company’s bank account.

In other words, the cash in the bank account is ready for use and at the company’s disposal.

But for accrual accounting, the cash flow statement is required to understand the real liquidity position of the company.

The cash flow statement tracks the non-cash add-backs and changes in working capital among various other factors that impact the cash balance.

Under accrual accounting, the cash balance shown on the balance sheet might not be an accurate representation of the company’s actual liquidity – which explains the importance of the cash flow statement.

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The Difference Between the Cash Basis and Accrual Basis of Accounting

The cash basis and accrual basis of accounting are two different methods used to record accounting transactions. The core underlying difference between the two methods is in the timing of transaction recordation. When aggregated over time, the results of the two methods are approximately the same. The timing difference between the two methods occurs because revenue recognition is delayed under the cash basis until customer payments arrive at the company. Similarly, the recognition of expenses under the cash basis can be delayed until such time as a supplier invoice is paid.

What is the Cash Basis of Accounting?

Under the cash basis,revenue is recorded when cash is received from customers, and expenses are recorded when cash is paid to suppliers and employees. It is most commonly used by smaller entities with less complex accounting systems.

What is the Accrual Basis of Accounting?

Under the accrual basis, revenue is recorded when earned and expenses are recorded when consumed. It is most commonly used by larger entities with more complex accounting systems.

Examples of Cash Basis and Accrual Basis Differences

To apply these concepts, here are several examples:

• Revenue recognition. A company sells $10,000 of green widgets to a customer in March, which pays the invoice in April. Under the cash basis, the seller recognizes the sale in April, when the cash is received. Under the accrual basis, the seller recognizes the sale in March, when it issues the invoice.

• Expense recognition. A company buys $500 of office supplies in May, which it pays for in June. Under the cash basis, the buyer recognizes the purchase in June, when it pays the bill. Under the accrual basis, the buyer recognizes the purchase in May, when it receives the supplier's invoice.

Usage of the Cash Basis and Accrual Basis

The cash basis is only available for use if a company has no more than $5 million of sales per year (as per the IRS). It is easiest to account for transactions using the cash basis, since no complex accounting transactions such as accruals and deferrals are needed. Given its ease of use, the cash basis is widely used in small businesses. However, the relatively random timing of cash receipts and expenditures means that reported results can vary between unusually high and low profits. The cash basis is also commonly used by individuals when tracking their personal financial situations.

The accrual basis is used by all larger companies, for several reasons. First, its use is required for tax reporting when sales exceed $5 million. Also, a company's financial statements can only be audited if they have been prepared using the accrual basis. In addition, the financial results of a business under the accrual basis are more likely to match revenues and expenses in the same reporting period, so that the true profitability of an organization can be discerned. However, unless a statement of cash flows is included in the financial statements, this approach does not reveal the ability of a business to generate cash.