We will be comparing and contrasting the cash basis accounting versus accrual basis accounting. What are these accounting systems? These are two different types of accounting methods by which a company can maintain their records.
How does a company know which one of these methods to use? Well it depends on their individual circumstances. But as a broad guideline smaller companies and service companies trend to use the cash basis accounting. Larger companies and companies that are selling inventory or maintain inventory trend to use the accrual basis accounting.
So let’s get right into an example to help us better appreciate and understand the differences between the two methods. So in the example here in the month of February a CPA opens up his practice for the first time and goes out and secures clients and completes work for them in the amount of $5,000. He does all of this in the month of February. He then sends out invoices also in the month of February out to his clients giving them 30 days payment terms.
So then we enter the month of March. In the month of March the CPA receives all of this $5,000 from his clients for work completed in February. Also in the month of March the CPA was unable to find any additional work, so he did absolutely no work in March. The only thing that happened in March was he received the $5,000 of cash for the work done in the month of February.
So the question then is which month there’s a CPA recognize revenues. Which month does the CPA recognize revenues? To answer that question let’s assume for a moment that the CPA maintains his own books on a cash basis. If the CPA were to maintain his own books on a cash basis, then in the month of February he records absolutely no revenues zero revenues. But in the month of March he records $5,000 worth of revenues.
What is the basis for this revenue recognition? The basis is in the guideline that I provided you when did the CPA receive the money? That’s a question you need to ask yourself when did the CPA receive the money. And as you can see in the month of February he received no money so therefore his revenues was zero, but in the month of March he received $5,000 of cash, so his revenues in the month of March are $5,000.
In accrual basis one of the CPA were to maintain his book on an accrual basis. How would he read which month would he recognize revenues? Then in the month of February he would recognize $5,000 of revenues. For the month of March his revenue recognition would be zero. Why is that? But let’s look at a guideline for accrual basis. When did the CPA earn this money?
The CPA would have earned the money in the month that he completed the work. So in this example the CPA completed the work and therefore earned the money in February which is why we record revenues of $5,000 in February. But in the month of March to recall he did no work so he did not earn any money and therefore his revenue recognition in March would be zero.
So in conclusion with cash basis accounting, revenues are recognized in the month in which you receive the money regardless of when you earned it. Let me repeat that again, and the cash basis accounting revenues are recognized in the month in which you receive the money regardless of when you earned it.
However under accrual basis accounting revenues are recognized in the month in which you earned it regardless of when you receive the cash. We’ll repeat that again. Under accrual basis accounting revenues are recognized in the month in which you have earned the money regardless of the month in which you receive the cash.
So that conclueds our discussion on the revenue aspects of cash basis accounting versus accural basis accounting.
We will be talking about the treatment of expenses and comparing and contrasting the treatment in the cash basis accounting versus accrual basis accounting.
When you start a company you can keep your books on a cash basis or an accrual basis how do you know which method to use. As a broad guideline if you’re a small company and a service company you would trend to go with the cash basis accounting. However if you’re a larger company and you’re selling inventory then you would trend to use the accrual basis accounting.
In this disccusion we will talk about expenses, so by way of example a CPA rents office space at the rate of $1,000 per month. In the month of February the CPA is unable to pay his office rent. However in the month of March he doubles up and pays $2,000 of rent that’s 1,000 to catch up for February which was past you and 1,000 for the current month of March.
So with this piece of information here’s a question, which month is a rent expense going to be recognized? Which month will the rent expense be recognized? The answer of course depends on whther the CPA is keeping his book on a cash basis or on an accural basis.
Well let’s assume that the CPA is keeping his books on a cash basis. If he is keeping his books on a cash basis, then in the month of February his rent expense will be zero, no rent will be recognized. However in the month of March the rent expense will be $2,000. Why is that? Here’s a guideline which month was a rent paid. Did he pay any rent in February? No, so the answer for rent expense is zero. Did he pay any rent in March and so yes he paid $2,000 of rent in March, so therefore you will pick up the entire $2,000 as rent expense for the month of March.
Let’s switch to the accrual basis same example, but what if the CPA had kept his books hypothetically on an accrual basis. How would then the rent expense recognition change for the same example same set of facts. Under the accual basis the CPA would pick up $1,000 of rent expense in February and $1,000 of rent expense in the month of March.
Why? Here is a guideline which month which month was rent expense incurred? And the answer is each of the month of February and March the CPA had incurred an obligation to pay the rent of $1,000,so therefore he had to show rent expense 1,000 and February and 1,000 and March.
Now some might find a preference for one method over the other all might argue that one method is more accurate than another method. And again it’s looking at a glass as half-empty or half-full, both sides in a have merits for the arguments.
So in recapping this discussion let’s look at the guidelines for expenses under both methods. Under the cash basis method expenses are recognized in the month in which the expense is actually paid, physically paid. Whereas an accrual basis accounting, expenses are recognized in the month in which the company incurres the obligation to pay regardless of when they paid it. Let me repeat again, under the accrual basis accounting expenses are recognized in the month in which the company incurrs the obligation to pay regardless of which month they actually paid it.
So again here the CPA incurrs the obligation to pay rent on the first of each month and therefore he had to pick up rent expense on for each month of $1,000 regardless of whether he paid rent it in a given month or not. So that concludes our discussion on the treatment of expenses in terms of the cash basis accountinig versus accrual basis accounting.