The cash basis and accrual basis of accounting are two different methods used to record accounting transactions. The core underlying difference between the two methods is in the timing of recording transactions. When aggregated over time, the results of the two methods are approximately the same. A brief description of each method follows:
The Cash Method
Revenue is recorded from the sale of goods or the performance of services in the year that payment is received, regardless of when the sale occurred or the services were performed.
Under the cash method, expenses are recorded in the year the expense is paid.
The Accrual Method
Revenue is recorded as the earning process with respect to the provision of goods or services is complete, regardless of when the payment is received.
Accrual basic firms match expenses against revenue in the year the liability for the expense is incurred, regardless of when payment of expense if made.
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To apply these concepts, here are few examples:
Revenue recognition: Firm ABC performed client services during September and October 2016 and billed the client for $10,000 on October 8, 2016. Under the cash basis, if ABC did not receive a check-in payment before the year-end, it would have not recorded revenue for the year. According to the accrual basis, ABC recorded these items even though it did not receive payment from the client in the following year.
Expense recognition: Firm ABC bought $600 of office supplies in May 2016 and paid for in June 2016. On a cash basis, ABC recorded the purchase in June, when it paid the bill. Under the accrual basis, ABC recognized the purchase in May as it received the supplier's invoice.
The cash basis is only available for use if a company has no more than $5 million of sales per year (as per the IRS). It is easiest to account for transactions using the cash basis due to no complex accounting transactions such as accruals and deferrals are needed. Also, it is widely used in small businesses; however, the relatively random timing of cash receipts and expenditures means that reported results can vary between unusually high and low profits.
The accrual basis is used by all larger companies, for several reasons. First, its use is required for tax reporting when sales exceed $5 million. Also, a company's financial statements can only be audited if they have been prepared using the accrual basis. In addition, the financial results of a business under the accrual basis are more likely to match revenues and expenses in the same reporting period, so that the true profitability of an organization can be distinguished. However, unless a statement of cash flows is included in the financial statements, this approach does not reveal the ability of a business to generate cash.
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