Cash Basis vs. Accrual Basis Accounting Explained

Introduction to Cash Basis Accounting

The cash basis of accounting is more likely to be used by service businesses than by retail or manufacturing businesses. Service businesses usually do not need equipment and can deliver a service with nothing more than their own skills and expertise. Lawyers, writers, public relations and advertising professionals, and accountants are common examples (Edmonds, McNair, Milam, and Olds, Fundamental Financial Accounting Concepts, 4th edition, McGraw-Hill Irwin, 2002).

Under the cash basis, business records track "cash in" (deposits to the bank account), called cash receipts, and "cash out" (checks written), called cash disbursements. The basic equation is: Cash Receipts − Cash Disbursements = Cash Flow. Each month's cash flow is added to the preceding month's cash balance to yield the current month's cash balance.

Unless a business is a small service company, it generally cannot determine whether it is earning a profit using cash accounting alone. There are two reasons for this limitation. First, cash receipts and disbursements related to the same business activity do not always fall in the same month. For example, a lawyer may perform a real estate closing in May, pay for photocopies related to that closing in May, and not receive payment from the client until June. The disbursement and the receipt therefore occur in different months. Second, some cash disbursements are made for assets that provide a gradual benefit to the business over time — property and equipment are clear examples of this.

Accrual accounting differs from cash accounting in that it measures a broader range of financial activity: cash and other assets, owner's equity, cash flow, and profit (typically referred to as income or net income). Accrual accounting uses four financial statements to track an enterprise: the balance sheet, the income statement, the statement of cash flows, and the statement of changes in owner's equity (or statement of stockholders' equity).

The balance sheet is based on the equation: Assets = Liabilities + Owner's Equity. It shows the owner's equity as of a specific date. The income statement is based on the equation: Revenues − Expenses = Net Income (or Loss), and it shows how much profit or loss a business generated during a specific period. Accrual accounting matches expenses with the revenues used to generate them, allowing profit to be measured consistently from period to period.

Overview of Accrual Basis Accounting

Under the cash method, a business reports income when it is actually received and reports expenses when cash is actually disbursed. Under the accrual method, a business reports income when it has the right to receive that income, and reports expenses when all events that create the liability have occurred and the amount of the expense is reasonably determinable. These distinctions can produce meaningfully different pictures of a business's financial health for any given accounting period.

The following side-by-side income statement templates illustrate how the same farm operation — AXY Farms — reports its financial results under each method for the year ending December 31.

Receipts
Cash grain sales
Government program payments
Total Cash Receipts

Expenses
Cash operating expenses
Interest paid
Total Cash Expenses
Depreciation*
Total Expenses

Key Differences Between the Two Methods

Net farm income from operations (cash basis)
Gain/loss on sale of farm capital assets
Net farm income, before tax (cash basis)
Income taxes & S.S. taxes paid
Net Farm Income, After Tax (cash basis)

Revenues
Cash receipts from grain sales
Change in grain inventory
Government program payments
Change in accounts receivable
Gross Revenues

Conclusion

AXY Farms appears to be moderately profitable on a cash basis. However, after adjusting the cash basis income statement to approximate an accrual basis income statement for the same period, net income after tax increased from $18,000 to $46,000. Because of the accrual adjustments, gross revenues were greater by $25,000 (from $175,000 to $200,000), while total expenses were less by $19,000 (from $149,000 to $130,000). However, because of the accrued and deferred income taxes, the expense for income taxes increased by $16,000 (from $8,000 to $24,000). After making the accrual adjustments to the income statement, AXY Farms was shown to be more profitable than the cash basis method had indicated.