What the difference is between accrual basis and cash basis accounting is something I am often questioned about as a part time CFO. QuickBooks users know that by clicking QuickBooks’ “modify report” button, the user is presented with the choice of reporting their financial statements under a either a cash or accrual reporting basis. Depending on their choice, my clients notice a significant discrepancy in their profit and wonder why. Explaining the differences between a cash and accrual reporting basis is one of my CFO services.
Revenues are recognized under the accrual reporting basis whether the cash on the sale is received or not in the month the product is sold or the service is performed. For example, if you ship computers to the customers you sell them to with 60 day terms in the month of May, the sale will be recognized in May (not 60 days later in July when the cash will actually be received) under the accrual basis. Expenses are recognized when they are incurred, not when they’re paid under the Accrual Reporting Basis. Going back to the example, if part of your cost producing those computers was hiring outside contracted labor with 30 day terms the expense would be recorded in May (even though you paid for it in June).
Revenues are recognized in the same month the product is paid for by the customer, not the month its shipped under the Cash Reporting Basis. Returning to the example, say the computer is shipped to the customer in the month of May with 60 day terms. The sale will be recognized in July when it was paid for under the cash basis, not May when it was shipped. Expenses under the cash reporting basis are recognized when they are paid, not when they’re incurred. For example, if part of your cost to produce the computers you built and shipped in May were to hire outside contracted labor with 30 day terms the expense would be recorded when you paid the expense in June and not when you incurred the expense in May.
How do you know which is better than the other? Is one better than the other? Both are allowed for income tax purposes, and an income tax professional should be consulted to figure out which is best for you. For management purposes, the accrual basis is, in my personal opinion, a much better choice because it provides a more accurate matching of expenses with revenues. Taking a look at the computer company example under the Accrual method the product is shipped in May and revenue is recognized. The expense associated with the product (outside contractors) is recognized in May when incurred. This is a perfect match of revenues with the expenses that produced that revenue. Now take a look at the same example under the cash basis. The revenue would be recognized when paid in July and the expense would be recognized when paid in June. There you have an obvious mismatching of revenues and expenses.
Through utilization of the accrual basis and the proper matching of revenues with expenses more useable management reports are available and in turn better decision making. Certainly the CFO as well as the business owner will be able to better utilize and make more effective judgments with the accrual basis of accounting. As previously mentioned the IRS allows for both methods of accounting however under GAAP (Generally Accepted Accounting Principles) only the accrual reporting basis of accounting is allowed.