What's the difference between cash and accrual in accounting?

Question

One of the hardest concepts for new Accountants to grasp is the difference between cash based accounting and accrual accounting.

Answer 1

_{Cash Accounting}

1. Records income and expenses only when cash actually changes hands
2. You record income when you receive payment, and expenses when you pay a bill
3. Easier to manage and ideal for very small or cash-based businesses

Example:

You send an invoice in March but don’t get paid until April. With cash accounting, you record that income in April, when the money hits your account.

Accrual Accounting

1. Records income and expenses when they are earned or incurred, regardless of when the cash is received or paid
2. Gives a more accurate picture of your business’s financial health over time
3. Often required for businesses with inventory or larger revenues

Example:

You send that same invoice in March. Even if payment comes in April, you record the income in March, because that’s when you earned it.

Answer 2

Cash-Based vs. Accrual-Based Accounting

Cash-Based Accounting records revenue and expenses only when cash is received or paid. It’s simple to use but can be easily manipulated to distort earnings. For example:

1. A business can delay invoicing customers until after year-end to reduce current-year income.
2. It can postpone paying suppliers to increase current-year profit.

Because of this potential for manipulation, GAAP (Generally Accepted Accounting Principles) does not permit cash-based accounting for most businesses.

Accrual-Based Accounting, required under GAAP, recognizes revenue when earned and expenses when incurred, regardless of when cash is exchanged. It aligns income and expenses with the period they relate to, giving a more accurate picture of financial performance. For example:

1. Prepaid Insurance: If you pay $1,200 in December for coverage from January to December of the following year, cash-based accounting expenses the full $1,200 immediately. Under accrual accounting, you expense $100 per month as the coverage is used.
2. Revenue Recognition: If you make a sale in December but receive payment in January, accrual accounting records the revenue in December, when the sale occurred and the revenue was earned.

Summary:

1. Cash-Based = Simpler, but less accurate and open to timing manipulation.
2. Accrual-Based = GAAP-compliant, reflects true financial activity by matching revenues and expenses to the correct periods.

NOTE: If you'd like to become more familiar with accrual-based accounting, look up adjusting entries, they are key to applying this method accurately.

Answer 3

The way I like to explain it is:

CASH BASED ACCOUNTING

What happens in the bank is what happens in the books.

ACCRUAL BASED ACCOUNTING

What happens in the business is what happens in the books.

So yes, it's a bit more complex than this, but if you are a student and you're just learning about Accounting, this may help you. Good luck with your studies! I hope I'll see you as a student sometime!