Differences Between Cash Accounting and Accruals Accounting

There are two main methods of accounting used in the business: cash accounting and accruals accounting. The basic difference is the timing of income and expense recording. The choice of the method depends on the factors like the nature of the business, ease of use or regulations by the related laws.

In cash accounting income is recognized when cash is received or deposited and expenses are recorded when bills are paid. Therefore transactions are recorded only when cash is handed over. Consequently non-cash transactions are excluded (such as provisions and revaluations).

In accruals accounting, economic events are recognized by matching revenues to expenses (the matching principle) at the time in which the transaction occurs rather than when payment is made (or received). Therefore accruals accounting measures the performance and position of a company by combining current cash flows with future expected cash flows, giving a more accurate picture of current financial condition.

The accruals concept and matching principle can be illustrated simply with the following example. Suppose a business had the following transaction at given times:

  • Company purchases goods costing £100 on credit on 15 January.
  • Bills are paid on 15 February for the goods purchased on 15 January.
  • These goods are sold on credit for £150 on 15 March.
  • On the 15 April Company receives payment for the goods sold on 15 March.

In the accruals accounting transactions are recognized in the following months:

  1. The cost of goods is incurred in January.
  2. The sales revenue is earned in March.
  3. There is no profit or loss in January, February or April.

The only profit was earned in March which was £50 in total. The cost of goods is recorded as stock at the end of January and February.

As opposed to the accrual method, cash accounting would record same transactions in the following months:

  1. The cost of goods is incurred in February.
  2. The sales revenue is earned in April.
  3. The profit is earned in April.

Accruals accounting is perceived as the standard practice in the business. Only in the certain cases, the small companies still may prefer cash accounting as they are less likely to operate on credits. Accrual method provides more accurate picture of company’s current financial condition and their financial statements are relatively more detailed. Accrual basis balance sheets have more items to be listed as they record non cash transactions.

Following is an illustration of differences between cash basis and accrual basis financial statements. Take an example of a weekend school operating on donations. At the end of the fiscal year, school has recorded its transactions based on its check book to produce cash basis income statement and balance sheet:

Cash basis statements
Income statement as at 31 December 2006     
   
Income  
    Grants £3.000
    Contributions £4.500
    Fees from students £25.000
    Total Income £32.500
   
Expenses  
    Salaries £20,000
    Food and supplies £6.000
    Insurance £4.250
    Utilities £2.000
    Telephone £750
    Printing and postage £3.500
    Total expenses £36.450

 

Balance Sheet as at 31 December 2006   
   
Fixed assets  
    Property and equipment £120,000
    Accumulated depreciation <£100,000>
Current assets  
    Cash £2.500
Less: Current Liabilities  
    Loan from founder £10,000
   
Net current assets £12. 500

All these activities have been taken from the check book, so these statements were produced on cash basis. This results in some of the pertinent information missing from the statements. Such as:

  • Local government authorities had given a grant of £15.000 to provide scholarship for low-income students.
  • There have been some students who attended school during last academic year and paid their fees in check, which has not been yet cashed. And this amounts £3.000 in total.
  • The school management did not pay the final installment for some of the goods that they bought last year. They still owe £2.000 to the creditors.
  • Company has already paid its insurance for the next 3 months in advance to the date of this statement is made. Therefore we can deduct (4250/12) x 3 = 1.062 from the insurance item.

If we want to take these factors into account all transactions need to be recorded on accrual basis. In order to do this we’ll add new items to financial statements and reproduce it on accrual basis. Followings are accrual basis statements of this weekend school for the same fiscal year.

Accrual basis statements
Income statement as at 31 December 2006  
   
Income  
    Grants £18.000
    Contributions £4.500
    Fees from students £28.000
    Total Income £50.500
   
Expenses     
    Salaries £20,000
    Food and supplies £6.000
    Insurance £3.188
    Utilities £2.000
    Telephone £750
    Printing and postage £5.500
    Total expenses £37.438

 

Balance Sheet as at 31 December 2006  
   
Fixed assets  
    Property and equipment £120,000
    Accumulated depreciation <£100,000>
Current assets  
    Cash £2.500
    Accounts Receivable £18.000
    Prepaid Expenses £1.062
Less: Current Liabilities  
    Loan from founder £10,000
    Accounts Payable £2.000
   
Net current assets £29.562

We have added three more items to reflect accruals on the balance sheet. These are “accounts receivables” for the transactions which have not yet received, “prepaid expenses” which have already paid and “accounts payable” for the items which company is liable to pay.

It is obvious that, accruals accounting requires more work to collect data and more resources are needed other than check book. We can say that cash accounting is much easier in terms of populating data and to produce financial statements. This is why still some of the small companies prefer to use cash accounting.
The very obvious reasons for choosing cash accounting can be summarized as follows:

  1. Cash accounting principles are easier to understand than that of the accrual accounting principles.
  2. Considering the costs involved in hiring accountants for accrual accounting, cash accounting seems to be cheaper.
  3. In terms of tax planning, cash accounting is more attractive since the company is taxed on its current cash flow, not from the accounts receivables.

Given these advantages there are still companies which might see cash accounting more attractive for their business. However accrual accounting is now regarded as a industry standards and also not all companies has the freedom of choosing any accounting method since it is controlled by the governmental authorities.

1 comment:

marry jhon said...

Well, this information is really helpful to me. Actually I am planning to learn more on finance and so I was searching some thing new in the finance course.



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