CASH VS. ACCRUAL BASIS

Accounting records prepared using the cash basis
recognize income and expenses according to real-time
cash flow. Income is recorded upon receipt of funds,
rather than based upon when it is actually earned, and
expenses are recorded as they are paid, rather than as
they are actually incurred. Under this accounting
method, therefore, it is possible to defer taxable income
by delaying billing so that payment is not received
in the current year. Likewise, it is possible to
accelerate expenses by paying them as soon as the
bills are received, in advance of the due date. The cash
method offers several advantages: it is simpler than
the accrual method; it provides a more accurate picture
of cash flow; and income is not subject to taxation
until the money is actually received.
Since the recognition of revenues and expenses
under the cash method depends upon the timing of
various cash receipts and disbursements, however, it
can sometimes provide a misleading picture of a company’s
financial situation. For example, say that a
company pays its annual rent of $12,000 in January,
rather than paying $1,000 per month for the year. The
cash basis would recognize a rent expense for January
of $12,000, since that is when the money was paid,
and a rent expense of zero for the remainder of the
year. Similarly, if the company sold $5,000 worth of
merchandise in January, but only collected $1,000
from customers, then only $1,000 would appear as
revenue that month, and the remainder of the revenue
would be held over until payment was received.
In contrast, the accrual basis makes a greater
effort to recognize income and expenses in the period
to which they apply, regardless of whether or not
money has changed hands. Under this system, revenue
is recorded when it is earned, rather than when
payment is received, and expenses recorded when
they are incurred, rather than when payment is made.
For example, say that a contractor performs all of the
work required by a contract during the month of May,
and presents his client with an invoice on June 1. The
contractor would still recognize the income from the
contract in May, because that is when it was earned,
even though the payment will not be received for
some time. The main advantage of the accrual method
is that it provides a more accurate picture of how a
business is performing over the long-term than the
cash method. The main disadvantages are that it is
more complex than the cash basis, and that income
taxes may be owed on revenue before payment is
actually received.
Under generally accepted accounting principles
(GAAP), the accrual basis of accounting is required
for all businesses that handle inventory, from small
retailers to large manufacturers. It is also required for
corporations and partnerships that have gross sales
over $5 million per year, though there are exceptions
for farming businesses and qualified personal service
corporations—such as doctors, lawyers, accountants,
and consultants. A business that chooses to use the
accrual basis must use it consistently for all financial
reporting and for credit purposes. For anyone who
runs two or more businesses, however, it is permissible
to use different accounting methods for each.