While generally accepted accounting principles require accrual accounting for external financial statements, many small businesses find that cash-basis accounting is both simple and fits their needs. If you are setting up a small business, spending the time to understand the choice between accrual and cash-basis accounting can save you costs of switching later.
Assets - Accrual Accounting
In accrual accounting, an asset is recognized as soon as the firm has legal ownership, the asset value can be reasonably estimated and, if applicable, when collectibility can be reasonably assured. It is important to note that the transfer of cash has no bearing on when an asset is recognized. This is most apparent when considering accounts receivable. Even though cash hasn't been received, the company books an asset to demonstrate the future benefit.
Assets - Cash Accounting
Under the cash accounting paradigm, transactions are only booked when cash changes hands. In the case of an asset purchase, when cash is paid to the seller the reduction of cash and the increase in assets are both recorded. While this is much simpler than accrual accounting, it often does not reflect the economic reality of the transaction. For example, if a company prepays rent for the upcoming year, all of the expense for the year is recorded in the month that the cash payment is made, even though the company receives the benefit of the rented building over the entire year.
Expenses - Accrual Accounting
Accrual accounting requires recognition of expense when the business becomes responsible for the amount. Many times businesses are billed for utility costs in the month after the utility is actually used. Under accrual accounting, businesses should recognize a liability and matching expense for utility costs as of the end of the month, even though the bill hasn't been received. This allows the company to match the business expenses with the revenues that are earned over the same period.
Expenses - Cash Accounting
Cash accounting rules only allow for the recognition of an expense when cash changes hands. For example, if a manufacturer is billed for water usage on an annual basis, the company does not recognize a liability or expense until the bill is paid. If the bill is late or doesn't arrive, the company doesn't make an entry into the accounting records. This technique is known as the checkbook method of accounting and comes with some major limitations. By only recording expenses when bills are paid, the company may be able to shift expenses into other periods in order to make the company look more profitable simply by manipulating when payments are made. This can make the financial statements misleading.
- Principles of Financial Accounting: Kermit P. Larson, et al.
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