Large Categories of Accounting Methods

¶ … large categories of accounting methods that companies tend to use: cash and accrual. The essay below will attempt a definition of both concepts, as well as a comparison between the two methods and general recommendations about when it is advisable to use one or the other.

According to several articles and web pages, the cash basis accounting method is meant to "report an expense when it is paid, and record income when it is received." This means that the expense that needs to be paid or the revenue that is made are recording in the books the moment they are received.

Let's have a few examples in order to better understand this methodology. We should assume that we are working for a consultancy firm and that we have provided a service for another company. The moment the respective company issues a check for us is the moment that we can record the respective revenue in our books.

The accrual methodology, on the other hand, "records income when the sale occurs, whether it be the delivery of a product or the rendering of a service on your part, regardless of when you get paid." The expenses are similarly recorded when the liability is contracted.

For example, in December, we buy equipment worth $20,000, payable over a period of six months. With the accrual accounting method, the respective expense is recorded in the month it was produced and not in every six months to follow during which the payments are made.

One of the problems that may arrive when using the accrual method refers to the fact that sometimes the exact moment when the transaction or the liability was contracted is not known. As a general convention, "the key date here is the job completion date." Indeed, the moment when the expense or the income is considered to be contracted is the moment when the sale has occurred, when the product has been purchased or, if we refer to a service, when the service contract between the two parties is ended and service is no longer provided. As a common example, even if you only need to add the finishing touches, theoretically you are not allowed to register it in the books until the job is fully completed.

Following this description of the two accounting methodologies, we are able to draw some comparisons between the two. The key issue is the moment that the operation is recorded in the books. Every other difference between these methods derives from this.

The accounting method that is being used significantly modifies the taxes the company pays. There are two examples worth mentioning. The first one refers to accelerated expenses. Indeed, if we use the accrual accounting method, considering the fact that each expense is recorded when the liability is contracted, this means that every purchase and expense can be recorded in the current fiscal year and be deducted at the same time, even if the actual payment will not be made until the next year. If we compare this to the cash accounting method, the company can only register the expense if it is paid.

The same case is reasonable to consider if we refer to employee bonuses, that can be recorded in the current fiscal year and deducted there from, albeit the fact that they will only be paid the year to come.

These two examples may lead us to believe that the accrual method is more appropriate between the two. This is not necessarily so. Indeed, the cash methodology has many advantages as well. In my opinion, the most important is the fact that it gives a clear and real picture of the financial and, especially, of current assets and liabilities within the company. Additionally, liquidity and ability to make payments is never overestimated with the cash basis accounting method. With the cash method, you are able to tell at any case how much cash your company has, which guarantees that you are not likely to be brought to a situation of illiquidity. With the cash method, one always knows the state of the company's cash flows.

On the other hand, the cash method has several important disadvantages. First of all, statistically and from a management point-of-view, it does not give a clear representation of the actual progress of the company. If we take the net revenues from sales, for example, this may point out during a certain month of the year, February for example, extremely high levels and could show a spectacular increase in overall sales. Nothing could be more false: it only records payments that were not made during December and the pre-holiday season and that were left for after the holidays. In this sense, the company could have actually sold nothing in February, but only counted the payments made for sales in December.

As such, if we look at this previous example, we may conclude that the cash method, while reflecting the cash situation in the company, does not reflect the evolution and the actual state of the business and the company.

Following the reasoning presented previously, the accrual methodology has two distinct advantages over the cash method. First of all, it "is more accurate in terms of net income." Indeed, at any given time, you are able to evaluate overall net income provided by the company's operations.

Second of all, it is "more realistic for measuring business performance." As I have previously discusses, the accrual method lets a manager analyze and decide on the actual performances of the company. In this sense, if he were to look in December over the accounting books, he would be able to see the actual sales figures, as the company had produced them the respective month.