| Cash basis Cash-basis accounting is a | | | | agent). The details of the actual cash |
| method of bookkeeping that records | | | | flows and their timing are tracked by |
| financial events based on cash flows and | | | | bookkeeping. |
| cash position. | | | | Comparison Using cash-basis accounting, |
| Revenue is recognized when cash is | | | | income and expenses are recognized only |
| received and expense is recognized when | | | | when cash is received or paid out. |
| cash is paid. In cash-basis accounting, | | | | Using accrual-basis accounting, |
| revenues and expenses are also called | | | | receivables and payables are recognized |
| cash receipts and cash payments. | | | | when a sale is agreed to, even though as |
| Cash-basis accounting does not recognize | | | | yet, no cash has been received or paid |
| promises to pay or expectations to | | | | out. |
| receive money or service in the future, | | | | Cash-basis accounting defers all credit |
| such as payables, receivables, and | | | | transactions to a later date. It is more |
| prepaid expenses. | | | | conservative for the seller in that it |
| This is simpler for individuals and | | | | does not record revenue until cash |
| organizations that do not have | | | | receipt. In a growing company, this |
| significant amounts of these | | | | results in a lower income compared to |
| transactions, or when the time lag | | | | accrual-basis accounting. |
| between the initiation of the | | | | A simple example A small business such |
| transaction and the cash flow is very | | | | as a fruit stand, which buys its |
| short. | | | | inventory daily for cash at a wholesale |
| Two types of cash-basis accounting | | | | market, sells the inventory for cash, |
| exist: strict and modified. Strict | | | | and throws away what didn't sell, can |
| cash-basis follows the cash flow | | | | get an accurate picture of its profits |
| exactly. | | | | or losses using cash-basis accounting. |
| Modified cash-basis includes some | | | | A remodeling business that gives |
| elements from accrual-basis accounting | | | | customers 90 days to pay and that |
| such as inventory and property | | | | procures materials on account at the |
| capitalization. | | | | lumber yard, must use the accrual method |
| Issues with cash basis Cash-basis | | | | to gain an accurate picture of its |
| accounting fails to meet GAAP | | | | financial condition. |
| requirements because it does not adhere | | | | Either business will probably get a |
| to the following two GAAP principles: | | | | relatively accurate picture using either |
| Revenue recognition principle - revenue | | | | method over a long period of time, |
| should be recognized when it is realized | | | | except for the transactions that have |
| (e.g. a credit sale) Matching principle | | | | already begun that are not yet closed. |
| - revenue should be matched to the | | | | Other considerations Standard |
| expense if possible (e.g. | | | | accrual-basis financial statements |
| sales to COGS) Additionally, cash-basis | | | | (profit statements and balance sheets) |
| accounting is not viable for cost | | | | do not indicate the cash inflows and |
| accounting in manufacturing operations | | | | outflows of a company. The Statement of |
| because expenses cannot always be | | | | Cash Flows is created to indicate that |
| correctly associated with product costs. | | | | information for accrual-basis |
| Example When you pay your rent, your | | | | accounting. |
| landlord would record an income event at | | | | Accrual-basis accounting is more costly |
| the time he receives your payment. The | | | | to maintain, because it requires the |
| landlord would subsequently record an | | | | bookkeeper to record a lot more |
| expense event when he pays the rental | | | | transactions. However, the advent of |
| agent their fee for your apartment. It | | | | accounting software has made the |
| is the accounting method used by most | | | | difference between the reporting methods |
| individuals, and by some businesses, | | | | less significant. |
| that have limited payables or | | | | Companies that have extended or used |
| receivables or whose income and expense | | | | credit significantly should use (and in |
| cash flows are closely associated with | | | | the United States may be required by the |
| each other in time. | | | | Internal Revenue Service to use) the |
| Accrual basis Accrual-basis accounting | | | | accrual-basis method of accounting. The |
| records financial events based on events | | | | U.S. Securities and Exchange Commission |
| that change your net worth (the amount | | | | requires that all publicly traded |
| owed to you minus the amount you owe | | | | companies follow GAAP, thus all publicly |
| others). | | | | traded companies publish their financial |
| Standard practice is to record and | | | | statements using accrual-basis method. |
| recognize revenues in the period which | | | | Three kind of external stakeholders |
| they incur and to match them with | | | | should be considered when deciding the |
| related expenses in a process known as | | | | reporting method: creditors stockholders |
| matching or expense matching. Even | | | | taxation authorities For the creditors |
| though cash is not received or paid in a | | | | and stockholders of large enterprises, |
| credit transaction, they are recorded | | | | cash basis accounting is financially |
| because they are consequential in the | | | | inadequate. It does not project the |
| future income and cash flow of the | | | | future cash flow of the company. |
| company. | | | | For tax purposes, cash basis accounting |
| Accrual-basis is GAAP compliant. | | | | is highly favored because it defers tax |
| Example Your landlord would record an | | | | burdens until the cash is received. It |
| income event on the day your rent comes | | | | is often used by small businesses and |
| due (you owe it to him). He records an | | | | organizations that are not required to |
| expense event when the fee owed to the | | | | use the accrual method, both for tax |
| rental agent comes due for your | | | | reasons and for its simplicity. |
| apartment that month (he owes it to the | | | | |