Notes

Have you ever been in the wrong place at the wrong time? Or what about being at the right place at the right time? The one thing that is similar among both scenarios is timing. Timing is everything, and in accounting, it is the one major difference between cash-basis and accrual-basis accounting. How is that you wonder? Well, let's look a little deeper into the concepts of cash- and accrual-basis accounting, and you can see for yourself.

What Is Cash-Basis Accounting?
My momma always told me that you never count your chickens before they hatch. It took me years to understand exactly what she meant, but I finally did. She meant to never count on anything until it was in your hand.

In a sense, that is exactly what cash-basis accounting is. The literal definition of cash-basis accounting is the accounting system that recognizes cash when it is received and bills when they are paid.

As you can see, the chickens aren't counted until they hatch! This is the way that most of us handle our personal finances, but is it the best way for a business to operate?

What Is Accrual-Basis Accounting?
The accrual basis of accounting is just the opposite. In this form of accounting, you do count your chickens before they hatch! In the accrual form of accounting, revenue is recognized when it is earned and expenses when bills are received, regardless of when cash changes hands.

In reality, this is the form of accounting most used by businesses. Why would that be? Simply because the accrual form of accounting paints a better financial picture of what a company is really valued at by recognizing and recording income and expenses regardless of whether cash has been received or paid out.

Differences Between the Two
The main difference between these two forms of accounting goes right back to timing. Of course, timing has a partner here. It is called revenue recognition. Cash basis only records revenue when cash is received and not a moment before. It also only recognizes an expense when cash has been paid out. So, even if a bill is sitting on your desk, if it has not been paid, it is not considered an expense in cash basis accounting - at least not until you write a check to pay that bill.

In the accrual basis, revenue is recognized when it is earned and not when it is received. Expenses are recognized when bills are received regardless of when they're paid.

Another pretty important difference in these two forms of accounting is how well cash is tracked. Cash-basis accounting does an excellent job of tracking cash flow because it records the inflows and outflows only when they occur. However, it does a horrible job of matching revenues and expenses in the accounting period that they occur.

Accrual basis does an excellent job of matching revenues and expenses and a poor job of tracking cash flow because it recognizes income before it is received and expenses before they're paid.

A third example of differences between these two types of accounting methods is this: in order for a company to use cash-basis accounting, it can't sell items using in-house charge accounts that would result in an account receivable. It must only accept cash, check or credit cards as payment. Under the accrual basis of accounting, the company does have accounts receivables.

Example
Now that I have given you the basics on cash-basis and accrual-basis accounting, let's look at an example to help you understand how these two concepts really work in accounting.

Emmie owns a clothing boutique. Her friend, Jo, comes in and buys $250 worth of designer clothes and charges them to her store account. How is this transaction recorded using cash-basis accounting? It isn't. Because no money changed hands, there is nothing to record under the cash-basis method.

However, using the accrual method of accounting, there is information to be recorded. The Accounts Receivable account will be debited $250, and the Inventory account will be credited $250.

One month later, Jo pays her $250 bill. How is this transaction recorded using cash-basis accounting? Because there is an amount that's been paid, the $250 cash payment is recorded as income.

Using the accrual method, this transaction would be recorded as a $250 debit to Cash and a $250 credit to Accounts Receivable.

Lesson Summary
There are two methods that companies can use to perform accounting functions. Cash-basis accounting is the method of accounting that requires revenue be recorded when it is received and expenses when they are paid. Accrual-basis accounting requires that revenue be recorded when it is earned, regardless of when it is received, and that expenses be recorded when they are received, regardless of when they're paid.

Though both of these concepts are forms of accounting, there are definite differences between the two. The first major difference is in the timing of recognition of revenue and expenses. Cash-basis only records cash when it is received in hand and expenses when they are paid. Accrual-basis records cash when it is earned and expenses when they are received, regardless of when the revenue is received or expenses paid.

A second difference between the two is that cash-basis accounting does a great job of tracking the company's cash flow but a poor job of matching revenues with expenses. The accrual-basis is the direct opposite. It does a poor job of tracking cash flow and an excellent job matching revenues and expenses. A third difference in these two types of accounting methods is that cash-basis accounting is only used if a company has no accounts receivables, while accrual-basis is used if a company does have accounts receivables.

The bottom line in deciding what type of accounting method to use is to decide what type of business that you're going to operate.