There are two systems of bookkeeping most used today: the accrual method and the cash method. Though both are utilized, the accrual method is more accurate to the financial status of a company and is the favoured option for companies earning more than $5 million in sales per year. In the accrual method, financial information is reported in the accounting period in which transactions occurs. In the cash method, financial information is reported when cash payments occur.
In the accrual method, revenues are reported when they are earned, as opposed to when the cash is received. When payables are incurred, they are reported as liabilities. Net income comes from earned revenues and incurred expenses in that accounting period. Expenses are reported when best matched with revenues or when fully used. When earned, receivables are reported as assets. Since financial information such as assets, liabilities, and the amount of stockholders’ equity is reported in the accounting period in which transactions occur, the balance sheet is therefore more accurate. In generally accepted accounting principles, the accrual method is the required form.
In the cash method, revenues are not reported until cash is received. When payables are incurred, they are not reported as liabilities. Rather than based on earned revenues and incurred expenses during the accounting period, net income focuses on cash receipts and cash disbursements. Once cash is paid, expenses are reported. Since financial information is reported when cash payments occur, the balance sheet may omit certain assets and liabilities, leading to less accurate information during that accounting period. As such, the cash method may violate the matching principle of accounting and is more appropriate for small companies. However, certain small companies are able to utilize the cash method and receive income tax benefits.
For example, an engineering firm provides parts to a customer on July 30 for the amount of $3,000. A sales invoice is prepared, dated on July 30, and requires the sum in thirty days. Using the accrual method, the engineering firm has earned $3,000 in revenue and has earned a $3,000 receivable on July 30. That same day, the engineering firm purchases $500 of materials and an invoice is received, but will not be paid until August 3. Using the accrual method, the firm has incurred a $500 expense and a $500 liability.
On July 30, the engineering firm has earned $3,000 in revenue, incurred a $500 expense, and has earned a $2,500 net income. However, if the cash method is used, there will be no revenue, expenses, or net income reported in the July income statement. The $3,000 revenue could be reported in September if the customer pays in forty days. The $500 expense will be reported in August when the materials are paid for.
Therefore, the accrual method is more accurate than the cash method in reporting the revenues and expenses of July 30.
Advantages and Disadvantages of Accrual vs Cash Based Methods
In bookkeeping, there are two commonly used methods: accrual and cash based. The method you choose depends on your business and level of income. Many small businesses have a choice of either the accrual or cash based method. If income is above $5 million, the accrual method must be used. Also, if a business’s inventory of items for sale to the public and gross receipts are over $1 million, the accrual method must be used. Inventory includes merchandise sold and supplies intended for sale.
With accrual and cash based bookkeeping, neither method provides a complete picture of the financial status of a business. While the accrual method provides an accurate depiction of the daily transactions of a business, it may be inaccurate in terms of cash reserves, hindering cash flow. For example, if there is a delay between making a sale and earning revenue from that sale, the income ledger will be inaccurate for that accounting period.
Utilizing the cash based method will provide a more accurate depiction of a company’s cash amount, but may be less accurate when depicting long-term profitability. For example, the cash method may reveal uneven months of profit as delayed revenue is collected.
Choosing either method will affect tax deductions at the end of the year. If expenses from one tax year are not paid until the next, those expenses cannot be claimed as deductions using the cash method. However, because transactions are recorded when they occur as opposed to when payment is received, deductions can be claimed using the accrual method.