Understanding cash and accrual basis accounting

Stan Synder Stan Snyder, CPA and expert bean counter

The difference between cash and accrual basis accounting has to do with the time frame in which revenues and expenses are recorded and reported. Cash basis accounting will suffice if your business is a simple one. However, the accrual basis will give a more accurate picture of the results of business operations.

Comparing cash and accrual basis accounting

Cash basis accounting is a very simple form of accounting. When a payment is received for the sale of goods or services, a deposit is made, and the revenue is recorded as of the date of the receipt of funds — no matter when the sale was made. Checks are written when funds are available to pay bills, and the expense is recorded as of the check date — regardless of when the expense was incurred.

The primary focus is on the amount of cash in the bank, and the secondary focus is on making sure all bills are paid. Little effort is made to match revenues to the time period in which they are earned, or to match expenses to the time period in which they are incurred.

Accrual basis accounting matches revenues to the time period in which they are earned and matches expenses to the time period in which they are incurred. While it is more complex than cash basis accounting, it provides much more information about your business. The accrual basis allows you to track receivables (amounts due from customers on credit sales) and payables (amounts due to vendors on credit purchases). The accrual basis allows you to match revenues to the expenses incurred in earning them, giving you more meaningful financial reports.

Cash basis Accrual basis
Revenues are recorded when they are received, which may be before or after they are earned. Revenues are recorded when they are earned, which may be before or after they are received.
Expenses are recorded when they are paid, which may be before or after they are incurred. Expenses are recorded when they are incurred, which may be before or after they are paid.
Financial statements reflect revenues and expenses based on when transactions were entered rather than when revenues were earned or expenses incurred. Financial statements match revenues to the expenses incurred in earning them, and more accurately reflect the results of operations.
No receivables are recorded. A receivable is recorded when payment is not received at the point of sale.
No payables are recorded. Payables are recorded when payment is not made at the time of purchase.
No method of tracking partial payments is available. Revenues and expenses are recorded in full, even though partial payments may be made over extended time periods.

Should I use cash or accrual basis?

The primary advantage of the cash basis is that it is quick and easy. For a business that does not sell on credit, and pays bills as they are incurred, it may be all that is necessary. The cash basis records only cash transactions, making the cash account a crude measure of how well the business is performing.

However, when a business makes sales or purchases on credit, the cash basis does not accurately reflect the results of operations. The cash basis does not provide a system for managing unpaid bills or for tracking customer receivables.

When a business makes sales on account — i.e., on credit — the accrual basis of accounting will not only record the revenue in the proper time period, it will also keep track of accounts receivable: amounts due from customers on completed sales. The accrual basis matches revenue to the time period in which it was earned, making your financial reports more meaningful.

Expenses recorded on the accrual basis may be coded to the proper time period by entering bills in the accounts payable account. Using accounts payable also provides reports showing amounts owed to vendors, making it easier to organize and prioritize bills and manage your cash flow. The accrual basis gives a more accurate picture of profit or loss because it includes all revenues and expenses, paid or unpaid.

 Note   Another advantage of using the accrual basis in Microsoft Office Accounting is that an accounting system set up on the accrual basis can also generate cash basis reports. This is the best of both worlds, matching revenues to expenses and giving information on accounts receivable and accounts payable while still being able to generate reports that approximate what happened on a cash basis.

How do I record revenues on either the cash basis or accrual basis?

Most business owners understand accounts receivable intuitively. A business creates invoices at the point of sale and between the time the sale is made and the payment is received the company has accounts receivable. Therefore, to record revenues on the accrual basis, use the invoice form to record sales.

When cash is received at the point of sale, the cash receipts form is used and there are no accounts receivable on that sale. To record revenues on the cash basis, use the cash receipt form to record sales.

If you have been using cash basis and want to switch to accrual basis, pick a date — today's date works just fine — and begin recording transactions using invoices and bills. All reports before that date will be cash basis, and all reports after that date will be accrual basis.

How do I record expenses on the accrual basis?

The accounts payable process is merely the flip side of the accounts receivable coin. To use the accrual basis to record expenses, use accounts payable by first entering bills, and then issuing checks to pay the bills. The accounts payable flowchart demonstrates the flow of transactions in an accounts payable system.

Flow of transactions in accounts payable system

  1. The accounts payable process begins with an order placed with a vendor. The order may be verbal, or it may be represented by a purchase order. Many small businesses do not use purchase orders even though they are an excellent way to track orders and the details related to those orders.

 Note   In Microsoft Office Accounting Professional, purchase orders can be converted into bills, allowing the user to compare and verify the purchase order details to the bill at the time of entry.

  1. For those businesses not using purchase orders, the accounts payable process begins when a bill is received.
  2. Enter bills into accounts payable immediately upon receipt. File unpaid bills in an accounts payable file.
  3. Bills are filed alphabetically by vendor, with the newest bill on top.
  4. When bills are ready to be paid, the Pay Bills form shows all unpaid bills. It can be filtered by due date and sorted by vendor name or due date. Credits can be applied to individual bills and full or partial payments made.

 Note   Microsoft Office Accounting allows bills to be paid via check, electronic funds transfer, or credit card, all from the Pay Bills form.

  1. After the checks are generated in Office Accounting, you can use the program to print them. If you are using voucher checks, the program will print the reference number of each bill being paid on the voucher for easy identification by your vendor.

 Note   For information about ordering integrated checks designed for Office Accounting, click "Checks and forms" in the See Also box at the top of the page.

  1. Tear off the check stub and staple it to the bill. The check stub records the check date, amount of each payment, and reference number (the vendor's invoice number).
  2. File the bill with the check stub in the paid bills file. Paid bills should be filed in an organized manner, sorted alphabetically by vendor with the newest bills on top or in the front of the file. When you are looking for a paid bill, it is most commonly a recently paid bill. Filing the newest bills chronologically, in the front of the file, will make finding the one you want quick and easy.

How do I record expenses on the cash basis?

The cash basis records expenses by entering checks. The following flowchart shows the details of the cash basis payment process.

Flow of transactions in cash basis accounting

  1. The cash basis payment process begins with a bill. Because the cash basis does not use accounts payable, bills are not entered into the accounting system until they are paid. Purchase orders are not entered into a cash basis system, therefore you need to set up a manual filing system to track both purchase orders and unpaid bills.
  2. Cut a check and enter the check as an expense in the accounting system. The expense is displayed in your financial reports using the date of the check. This is the primary difference between cash and accrual basis accounting. Cash basis accounting records the expense using the date of the check to determine when the expense is reported in your financial statements. Accrual basis accounting uses the date of the bill to record the expense regardless of when the check is cut. Using the cash basis, there is no way to get accrual basis reports because information about the bill date — the actual transaction date — has not been entered.
  3. Remove the check payment stub from the check and staple it to the bill, and send the check to the vendor.
  4. File the paid bill in a paid bills file, sorted alphabetically by vendor, with the newest bills on top or in the front of the file. When you are looking for a paid bill, it is most commonly a recently paid bill. Filing the bills by vendor and chronologically, with the newest bill in the front of the file, will make finding the one you want quick and easy.

Hybrid systems — combining cash and accrual basis

Each system has it advantages and disadvantages. It is difficult, if not impossible, to maintain a purely cash basis accounting system that shows a complete picture of business operations. The accrual basis, while more accurate than the cash basis, requires several extra steps in recording transactions.

Many businesses use a hybrid system, writing checks for purchases when the date of the purchase is the same as the date the expense was incurred, and entering bills when the bill date is not in the same month as the check date. Likewise, the cash receipts form is used for sales where payment is received at the point of sale, and an invoice is used for sales made on credit. This method yields an accrual basis system, but has the advantage of ease of entry for cash purchases or sales.

Many businesses use this combination of invoices, sales receipts, checks, and bills. This hybrid system is completely acceptable from an accounting standpoint and produces accurate accrual basis financial reports as long as proper attention is paid to transaction dates.

Benefits and costs of accrual basis accounting

The extra effort required in using the accrual basis is offset by the organizational and reporting capabilities of your accounting system. The extra effort required to enter invoices and receive payments is offset by the ability to track details about amounts due from customers. The extra effort required to enter bills and pay bills is offset by the ability to track details about amounts due to vendors.

For example, after a vendor bill is entered into accounts payable, it can be tracked by using accounts payable reports.

  • In Office Accounting, the Financial History tab in the vendor record shows all bills, credits, and payments for that vendor.
  • The A/P Aging Summary and A/P Aging Detail reports show outstanding (unpaid) bills. Details of all accounts payable may be analyzed in the accounts payable aging report. The accounts payable aging report is a standard accounting report that shows the balance of all unpaid bills at any point in time. This is a good report to use to prioritize payments and manage cash flow.
  • The Profit and Loss report will show all bills — whether the bill has been paid or not — on the accrual basis, and only paid bills on the cash basis.
  • The balance sheet will show the vendor liabilities (unpaid bills) in the accounts payable account.

When bills are entered immediately upon receipt, any bill can be found by looking in the accounts payable reports. With this system, if a bill cannot be found in the reports or in the bookkeeper's inbox, you can be confident that it has not been received. Likewise, all unpaid invoices may be tracked in accounts receivable reports, and a complete history of customer payments may be found in the customer records.

While the cash basis of accounting will suffice if your business is a simple one, the accrual basis will, in most cases, give a more accurate picture of the results of business operations. Using the accrual basis, the profit and loss report will include revenues that have been earned but not received and expenses that have been recorded but not paid. The accrual basis allows you to generate reports on customer receivables and vendor payables, and send statements to customers detailing the amounts due. The balance sheet will show amounts due from customers (accounts receivable) as an asset, and amounts due to vendors (accounts payable) as a liability. In addition, using the accrual basis allows you to generate both accrual basis and cash basis reports. Using the cash basis will yield only cash basis reports.


About the author

Stan Snyder is a certified public accountant with over 25 years experience dealing with the accounting and computer problems that small business owners face. He teaches computerized accounting classes at Colorado Mountain College, and regularly consults with small business owners using accounting software of all types. If you have questions about this topic or another accounting topic, send Stan some feedback by responding to the question below "Was this article helpful?" Stan may use your questions or topic ideas in an upcoming column.

 
 
Applies to:
Accounting 2008