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