Cash vs. Accrual Accounting
There are two different underlying methods that can be used in an accounting system: cash-basis accounting and accrual-basis accounting. Under GAAP (Generally Accepted Accounting Principles), only accrual-basis accounting is allowed for producing financial statements due to something called the revenue-matching principle, which I will explain shortly. First, let’s take a look at the difference between cash and accrual accounting.
Under accrual-basis accounting, transactions are recognized and recorded at the time (or in the reporting period) they occur, even if no exchange of money actually takes place. Revenues and expenses are recorded when they are incurred or accrued, rather than when they are actually received or paid.
Example: Bob’s Bakery sells 150 loaves of bread to a local food distributor on account. This means that Bob’s Bakery will deliver the goods, but will not collect payment from the customer until a later date. Even though Bob’s Bakery has not received any payment yet, they will still record this transaction to show that they have earned the revenue and incurred the expenses of performing the sale.
Under cash-basis accounting, transactions that create revenues or expenses are only recorded at the time that cash or some cash equivalent is actually transferred from one party to another.
Example: Bob’s Bakery sells 150 loaves of bread to a local food distributor on account. Bob’s Bakery will not record the transaction until the distributor sends them a cash payment for the transaction.
Why don’t businesses use cash-basis accounting?
Cash accounting is how most people think of their money. They consider themselves to have whatever amount of money they have sitting in their wallets and bank accounts. Businesses, however, can’t do that. They need a more accurate way to keep track of how much money they have invested in inventory, buildings, machinery, etc. They also have to consider how much money they owe to their creditors, such as loans, purchases they have made on account, money owed to employees, etc. To be able to do that, they need to assign all of their business transactions special accounts so they can keep track of how they affect the company’s financial position.
In addition to making it easier (heck, just making it possible) to keep track of how so many transactions affect the financial position of the company, accrual accounting achieves another very important thing–it allows businesses to recognize and record revenues and expenses when they actually happen, rather than when they render or receive payment for them. While it may seem odd to normal people who think in terms of how much cash they have available, being able to see when revenues and expenses actually take place allows businesses to get a much better understanding of how well or how poorly they are actually doing at any given time.
By recognizing revenues and expenses in the accounting period in which they occur, accrual accounting meets the revenue-matching principle. This is a very important concept, which is why it is required by GAAP. As I already mentioned, recognizing revenues and expenses in the accounting period in which they occur allows businesses to get a more accurate view of their financial position. By requiring companies to use this method of accounting, GAAP ensures that people who read the companies’ financial reports (these people are know as users in accounting-speak) will also get an accurate view of the companies’ financial positions. The IRS requires all but the smallest sole proprietors to use accrual-basis accounting for the same reason.