Cash-basis and Accrual-basis Book Keeping
Source : Quora.com
The cash-basis and accrual-basis are two different approaches that bookkeepers can use to record the financial transactions of a business.
Generally, small businesses, not-for-profit organisations, some Government agencies and community associations use the cash-basis while larger for-profit businesses use the accrual-basis. This is because the cash-basis is quite simple to understand and maintain while the more complicated accrual-basis produces the more accurate assessment of the financial position and performance of the business. Tax laws and accounting standards generally give small organisations a choice as to which approach they will adopt. At the same time larger organisations and public companies are required to record their financial transactions using ONLY the accrual method.
The major difference between the accrual accounting method and the cash accounting method is the way in which revenue and expenses are recorded in the accounts of the business. This difference consequently leads to a different profit result for a given period depending on the approach adopted. This difference is detailed below:
- Cash-basis – Using the cash-basis, revenue is only recorded when the cash is actually exchanged i.e. when revenue is received as cash and when expenses are actually paid.
- Accrual-basis – By contrast, the accrual-basis records revenue at the moment that a legal obligation is created. (i.e. at the point when the goods are shipped or at the completion of a service for a customer regardless of when the cash is actually exchanged). Similarly, under the accrual accounting method, expenses are recorded the moment a business becomes legally obliged to pay the bill (i.e. at the point of goods receipt or at the completion of the service by a supplier).
Another key difference between the accrual accounting method and the cash accounting method is that the accrual accounting method properly applies the accounting concept of the ‘matching principle‘ while the cash accounting method does not.
Applying the matching principle in accounting, requires bookkeepers to record in the same period, the revenue and all the expenses incurred in earning that revenue. The matching principle ensures that profits (revenues less expenses) are accurately reported for each accounting period. i.e. revenue earned in one period is accurately matched against the expenses that correspond to that same period, so a truer picture of your net profits for each period can be calculated.
For this reason, the accrual accounting method requires end-of-period adjustments to be made to the business revenues (i.e. adjusting for unearned revenue) and expenses (i.e. adjusting for pre-paid expenses) while the cash accounting method doesn’t. These end-of-period adjustments create accounting transactions known as accruals.
Here is an example of how a transaction would be recorded differently using each method/approach:
Another graphic that may help explain the difference is provided below:
If required, I have written more on this topic in the following articles:
- What is cash accounting? – http://knol.google.com/k/nowmast…
- What is accrual accounting? – http://knol.google.com/k/nowmast…
- What are the advantages and disadvantages of cash Vs accrual accounting? –http://knol.google.com/k/nowmast…
This question crosses three specialist areas of knowledge: (1) accountancy (2) US tax law and (3) economics (corporate finance), so we may need to get a few perspectives before we get the right one.
The phrase is used in US Federal tax law in relation to their definition of taxable income and in particular the setting of the alternative minimum tax (AMT). According to http://tpcprod.urban.org/publica…, the AMT is
“A complex tax (either federal or state) designed to increase the income tax on businesses that the legislature believes pay too little relative to “standard” rules of taxation”
These US standard rules of taxation are strongly influenced by both financial accounting practices and economic principles of income measurement. So while tax, accounting and economics generally agree that income is calculated by deducting from revenue the expenses uncured in generating that revenue, they each have their own definition of what constitutes revenue and what qualifies as an allowable deduction.
Economics for instance, when calculating income or the net added value, allows for the deduction of the opportunity cost of equity-financed capital. The opportunity cost of equity-financed capital is defined well by Clint Poppens and http://financial-dictionary.thef…
It is the difference in return between an investment one makes and another that one chose not to make. This may occur in securities trading or in other decisions. For example, if a person has $10,000 to invest and must choose between Stock A and Stock B, the opportunity cost is the difference in their returns. If that person invested $10,000 in Stock A and received a 5% return while Stock B makes a 7% return, the opportunity cost is 2%. One way of conceptualizing opportunity cost is as the amount of money one could have made by making a different investment decision.
So, while the opportunity cost of equity-financed capital is accepted as an economic cost when calculating a firm’s EVA (Economic Value Add), it is not recognized by accounting standards (GAAP) as an accounting costs in determining business income and neither is it recognized as an allowable deduction when calculating your tax owed under U.S. Federal Tax law.