Accrual Accounting

Because of the potential economic distortions caused by recording only cash transactions, GAAP requires revenue and expenses to be recorded on an accrual basis. This means that a business records revenue when the earning process is complete, not necessarily when cash is received. For example, a tavern that allows customers to run a tab records revenue when the customer receives the drink, not when the tab is paid.

Similarly, an accrual basis of accounting requires expenses to be recorded when the business receives the goods and services, not necessarily when the business actually pays for them. If a bar receives a supply of napkins but does not pay for them for thirty days, the expense is recognized when the napkins are delivered and used, not when the bill is paid.

Advantages And Disadvantages Of Cash And Accrual Systems

A business that records revenue only when cash is received, and expenses only when they are paid is said to be on the cash basis of accounting. An obvious advantage of the cash basis over the accrual basis is that it is much simpler. An accrual system requires more accounts, including accounts receivable, accounts payable, inventory, prepaid expenses, and deferred revenue. Each of these accrual accounts requires making estimates and sometimes complex computations. As in machinery, the more moving parts the more potential problems.

The cash basis accounting approach requires no complex measurements or estimates. An expense is recognized only when a vendor is paid for a product or service. Revenue is recorded only when a customer or client pays for products sold or services rendered.

The disadvantage of the cash basis system is that for any particular short period of time operating results can be greatly distorted from economic reality. The distortions usually result from transactions occurring near the end of accounting periods.

Do Different Bases Of Accounting Always Provide Different Operating Results ?

The answer is no. If most of a firm’s sales are cash sales and most expenses are paid immediately, there is little difference between the measured operating results using a cash basis versus an accrual basis of accounting. However, if a business extends credit to customers, has credit extended to it, or carries significant amounts of inventory, the differences in reported operating results using the two approaches can be significant.

For many businesses, cash collections may lag behind earnings by two to three months. Payments on expenses may also lag as much as sixty days from the receipt of goods and services. In these cases, cash basis earnings may greatly differ from accrual basis earnings.

Over the entire life cycle of a business, cumulative operating results are the same under both bases of accounting. In fact, year to year the differences may not be that great if the levels of revenue and expense remain stable and the collection and payment cycles do not fluctuate. The greatest variation between accrual and cash basis accounting tends to occur in the initial and ending periods of a firm’s life cycle, or during periods of significant growth or decline. Short term monthly and quarterly reporting also can be greatly different. As our friend Jim indicated, accurate short term reporting is very important in managing a business.