Most people use the cash accounting method because of its simplicity, for example for personal accounting such as balancing a checkbook and filing tax returns. Many small businesses, especially sole proprietorships, also use cash accounting for its simplicity.
This is because cash accounting has some advantages over accrual accounting. Cash accounting is simpler to maintain, easier to understand, and simplifies tax filing by allowing individuals or businesses to take deductions for business expenses paid in cash, while paying tax on revenues only received in cash. This also gives individuals and businesses more leeway over their tax bill, by, for example, deciding when to pay bills.
Accrual accounting, on the other hand, provides more timely information since revenues and expenses are recorded when they occur. This follows the matching principle, which requires companies to report all revenue with the expenses that were required to generate that revenue for the period. Accrual accounting is also the reason double entry accounting is required, since not all transactions necessarily affect the cash account, as is the case in cash accounting.
When individuals or businesses use the cash accounting method, the income statement shows the same cash increase or decrease as the cash flow statement. When a company uses the accrual accounting method, net income does not necessarily equal cash.
Most businesses are required to use the accrual accounting method, including the following:
Cash Accounting and Accrual Accounting Illustration
Assume Sunny Sunglasses Shop purchases inventory for $1,950 in period one on credit. Sunny sells the same sunglasses for $6,500 in period one on credit.
In period two Sunny receives payment for the sale in cash for $6,500, and in turn pays for the inventory with cash in period three ($1,950). The cash and accrual accounting methods would account for net income during periods one, two, and three as follows:
|Cash Accounting||Period 1||Period 2||Period 3||Total|
|Accrual Accounting||Period 1||Period 2||Period 3||Total|
Notice that even though both methods result in the same total, the difference between the two methods lies in the timing of net income.
Cash accounting resulted in zero income in period one since no cash was received or spent. The cash method only recognized cash when received in period two, and expenses when paid with cash in period three.
Under accrual accounting, the company incurred an expense by purchasing the inventory in period one, even though no cash was spent. Revenue was recognized when earned, even though no cash was received at the time of the transaction.
Accrual Accounting and GAAP
Generally Accepted Accounting Principles (GAAP) requires that businesses use the accrual basis accounting method since this method more accurately represents the financial state of a business at a given point in time.
Accrual Accounting and the Statement of Cash Flows
The statement of cash flows reconciles the income statement reported under the accrual method to actual cash on hand. This is important since a company may report profits, but still be short on cash for one reason or another (e.g. customers’ nonpayment or bad debt) under the accrual method.
For this reason it is essential that financial statement users review all of the financial statements to get a complete picture of the business.
The examples presented on this website use the accrual method of accounting for the production of the financial statements.