Key Takeaways
- Cash Basis Accounting is a method of recognizing revenue and expense when cash is received or paid, regardless if the revenue is earned or the expense is incurred.
- Accrual Accounting is a method of recording revenue and expense when earned or incurred, regardless if cash is received or paid.
- The three principles associated with accrual accounting are Revenue Recognition Principle, Expense Recognition Principle and Matching Principle.
Introduction
Accounting is an information system that records and tracks a company’s financial transactions. These transactions are recorded and processed into useful information that is presented on the company’s financial statements.
Every time a business transaction occurs, they are recorded in the accounting books of the company. Timing is an important factor when you’re recording transactions. It greatly affects the presentation and reliability of information in the financial statements.
Let’s assume that your company sold 10 power banks (portable chargers) to a customer who simultaneously paid cash for the full price of the items. To account for the transaction, you would normally recognize a revenue at the same time that the sale materialized and cash was collected.
However, the question arises when the customer promises to pay at a later date even if the power banks were already delivered to them today. Would you recognize a revenue from the sale on the day that you delivered the power banks? Or would you defer recognizing it at a later date until cash was paid by the customer?
When recognizing and recording revenues and expenses, you may either use Cash Basis Accounting or Accrual Accounting. The main difference between these two accounting methods is the point in time or the timing at which revenue and expenses are recorded in the books.
Cash Basis Accounting
Cash Basis Accounting is an accounting method where revenues and expenses are recognized when cash is received or paid, regardless if the revenues are earned or the expenses are incurred.
Under the cash basis accounting, revenues and expenses are not recorded until cash is received or paid. As a result, all cash received by the company from the sale of products and services are treated as revenues even if they are not yet earned. On the other hand, all cash paid from the purchase of products and services are treated as expenses regardless if already incurred.
Let’s look at two examples to illustrate this method of accounting.
Example 1:
On April 20, Company A delivered goods to their customer and agreed to be paid in cash on April 29. If the company uses the cash basis accounting in recording revenue and expenses, they will only recognize and record the revenue from the sale on April 29, i.e. when cash payment was received. Revenue will not be recognized on April 20 when the goods were delivered since no exchange of cash has happened.
Example 2:
The employees of Company B are paid every 5th day of the month. For payroll period ending May 31, employees will get paid on June 5. If the company uses cash basis accounting, they will recognize payroll expense on June 5 when cash was paid to their employees. Even if the employees rendered their services to the company during May, payroll expense will only be recorded on June 5.
Cash basis accounting is usually used by small businesses that only use cash for all of their sales and purchase transactions. They usually don’t recognize and record receivables and payables in the accounting books.
You can easily determine the revenue and expenses of a business that use cash basis accounting by only looking at their cash account and bank statements. Deposits for the current month represent revenues for that month while check payments from the same month represent expenses for that month.
Advantages of using cash basis accounting
- Easier to implement than accrual accounting since only cash-related transactions are recorded.
- Preferred by small businesses with few transactions and and don’t use credit for their sales and purchases.
Disadvantages of using cash basis accounting
- Does not always reflect the economic reality of the transaction.
- The financial statements usually do not present an accurate picture of the financial position and performance of the company since cash basis accounting fails to match expenses to revenues (see Matching Principle below). As a result, lenders and investors may refuse to provide financing to the company.
- Detailed and tedious work is required to convert the cash basis accounting records into an accrual basis. However, some accounting software today offer both cash basis and accrual basis functions so you can almost instantaneously convert your financial statements from cash basis into accrual basis, and vice versa. Though manual checking of the cash balances should still be made to ensure that the software accurately converted the reports.
- The company may manipulate its taxable income by timing the cashing of checks as well as its payment of liabilities.
Accrual Accounting
Accrual Accounting is an accounting method where revenues and expenses are recognized when earned or incurred, regardless if when cash is received or paid.
Under accrual accounting, a revenue or expense transaction is recorded not when there was an exchange of cash in the hands of the parties involved but when the contract was satisfactorily performed, i.e., when the seller delivers the product or performs the service. This means that revenues and expenses can be recorded without actual cash being transferred to and from the business.
Accrual accounting involves two principles: Revenue Recognition and Expense Recognition.
Revenue Recognition Principle
Under the Revenue Recognition Principle, revenue is recognized when it is earned, regardless of when cash is received.
Revenue is considered earned and realized at the point of sale, i.e. when the service has been rendered or when the product has been delivered to the customer.
Revenue is realizable when it is probable that the company will receive payment. Thus, the collection of cash from the customer is not a requirement for recognizing revenue. However, if there is a degree of doubt regarding the collection of cash from the customer, the company should recognize an allowance for bad debts.
To illustrate this case, assume that Company C provided a service on credit to a client on February 1. They issued an invoice to the client who promises to pay the full amount on March 15. When will Company C recognize a revenue from their service?
The point of sale in the above scenario is on February 1 when the service was rendered. At this point, the revenue is already considered earned so the company should recognize a service revenue from the transaction on the same date. An accounts receivable will also be recorded since it is probable that Company C will receive cash payment from the client on March 15.
When a company issues an invoice and records an accounts receivable from the sale, revenue is also being recorded even though the business has not receive any cash from the customer. In the case of Company C, cash was not involved on February 1 yet the business was able to recognize a revenue.
Expense Recognition Principle
Under the Expense Recognition Principle, expense is recognized when it is incurred, regardless of when cash is paid.
An expense is considered incurred when a service or product is received from the supplier or used up by the company. The payment of cash to the supplier is not a requirement for recognizing expenses.
To illustrate, let’s assume that on June 4, Company D was billed by a laundromat company for the laundry services it received from the latter. They were able to pay the bill on June 10. When will Company D record an expense for the laundry services it received?
Company D should recognize the laundry expense as incurred on June 4 which is the date they received the bill, even if the actual cash payment was made on June 10. It is assumed that the services were already rendered by the laundromat when they issued the bill to Company D on June 4.
When a bill was received and an accounts payable was recorded on the purchase, an expense is recognized even without the business making cash payments to its suppliers. Even if no cash was paid out by Company D on June 4, an expense was still recognized and recorded by the company on that date.
Advantages of using accrual accounting
- Reflects the real economic substance of transactions and events.
- Since obligations to pay cash in the future are recognized, liabilities such as accounts payable and accrued payables may appear in the financial statements.
- The recording of accounts receivable and accrued receivables represent resources in the form of cash that will be received by the company in the future.
- The financial statements present an accurate picture of the financial performance of the company since expenses are matched with the revenues that they helped generate.
- The IFRS and US GAAP favors the accrual basis accounting over the cash basis accounting since it makes the information in the financial statement more reliable, accurate and transparent. It is also favored by investors and creditors.
Disadvantage of using accrual accounting
- Harder to implement than cash basis accounting.
- Since revenue can be recognized without actual cash inflow, there could be a huge disconnect between profits and cash, especially when the company could not collect cash from their customers on time. The company may appear profitable but can also be cash-starved.
Matching Principle
Under the Matching Principle, all expenses incurred during an accounting period should be properly matched against the revenues earned on the same period.
Another principle that is connected to accrual accounting is the matching principle.
The matching principle requires that all expenses that were incurred to generate income for the business should be properly identified and deducted from the income that they helped produce during the accounting period. The argument behind this principle is that the generation of revenue has always a cost or expense associated with it.
No reward in the form of sales will be generated without the business spending its resources to generate those sales. That’s why revenues and expenses that directly result from a transaction should be simultaneously recognized and recorded.
For example, when a lemonade store sells lemonade juice and records a revenue from the sale, any associated expense to produce the sold juice should be deducted from the sales revenue to correctly reflect income for that period. These expenses may include but are not limited to the following:
- Cost of the lemons, ice, sugar, and water used to make the juice.
- Cost of the electricity consumed by any electrical equipment used to make the juice.
- Cost of the plastic cups and straws that comes with the lemonade juice.
- Labor paid to the crew or employee preparing the juice.
If the above expenses were not matched and deducted from the sales revenue of the business, the profit during that period will be overstated and the figures that should reflect the actual financial performance of the business will be distorted. However, determining when expenses are incurred and when to associate them with revenue may sometimes be difficult.
That’s why there are three guidelines and methods that can be used when applying the matching principle with revenues and expenses: Cause and Effect Method, Systematic and Rational Allocation Method and Immediate Recognition Method.
Matching Principle - Cause and Effect Method
The Cause and Effect Method recognizes expenses on the basis of a direct association between the costs incurred and specific revenues. It involves the simultaneous and combined recognition of revenues and expenses that result directly from the same transactions.
For example, the costs of goods sold by a retailer is recognized at the same time as the revenue from the sale of those goods. So when an electronics retailer buys a smartphone for $1,000 and subsequently sells it for $1,200, the retailer will simultaneously recognize in the accounting books a sales revenue of $1,200 and an expense of $1,000 so that they will be matched in the same accounting period. The cost of the smartphone sold is the most direct expense incurred by the retailer for that sales transaction.
Another example is when an insurance company sells an insurance product through a sales agent. The company should record the payment of the agent’s sales commission as expense at the same point in time as it recognizes revenue from the sale of the insurance product.
Other examples of the cause and effect method are the recognition of bad debts expense, delivery expense and warranty expense.
Matching Principle - Systematic and Rational Allocation Method
Under the Systematic and Rational Allocation Method, when an asset is expected to generate revenue for a company over several years or accounting periods, the cost of the asset must be spread out and recognized as expense over the periods for which it is expected to provide benefits on the basis of systematic and rational allocation procedures. These allocation procedures are intended to recognize expenses in the accounting periods of which the economic benefits associated with them will be received by the company.
This method is used when there is an absence of a direct cause and effect relationship and the association of the expense with the revenue it helped generate can only be broadly or indirectly determined. In other words, if you could not directly associate an expense with a revenue under the cause and effect method, the systematic and rational allocation method could help by allocating the expense over several periods where economic benefits are expected to be received.
For example, let’s assume that you own a leather goods company. You purchased a large-scale laser engraving machine for $6,000. This machine will be used for engraving names and logos on your leather products.
In this example, the machine is expected to be used by your company for 10 years during its operations. The machine will surely benefit the company over that 10-year period but the cause and effect relationship between the cost of the asset and the future revenues it will help generate may not be directly and easily determined. In this case, the cost of the machine amounting to $6,000 should be systematically allocated and recognized as expense over its useful life of 10 years. This would result with a yearly depreciation expense of $600 over 10 years.
Common examples of the systematic and rational allocation method are the amortization of intangible assets and depreciation of fixed assets over several periods.
Matching Principle - Immediate Recognition Method
If the first two methods are not applicable for matching a particular expense to a revenue item, then the costs can be expensed outright in the period they are incurred. The Immediate Recognition Method is used when:
- An expense does not produce any economic benefits or future economic benefits are uncertain.
- Future economic benefits do not qualify, or cease to qualify, for recognition in the statement of financial position.
- There is difficulty of associating the expense with future revenue.
- No allocation method can be applied to the cost.
Examples of expenses that can be immediately recognized are period costs such as general administrative expenses. These expenses include salaries, advertising, and loss from disposal or sale of fixed asset. Accrued expenses that are not yet paid such as utilities, rent, and interest are also immediately recognized at the end of the accounting period.
However, you should remember that the instances set above for the use of immediate recognition method should be met before charging any cost as outright expense. If the expense can still be associated to a revenue, then the first two methods should be used.
Review Questions
- Why do most businesses, auditors, creditors, and investors prefer accrual accounting over cash basis accounting?
- Why are financial statements prepared under accrual accounting more accurate?
- What are the advantages and disadvantages of using cash basis accounting?
- Why is there a need to match expenses with revenues?
- What is the difference between the systematic and rational allocation method and the cause and effect method?
