The two main methods of recording accounting transactions are cash basis accounting and accrual basis accounting. Each method has both advantages and disadvantages. However, only one method is approved by GAAP.
Cash Basis Accounting
Cash basis accounting is the method in which cash receipts and cash payments are recorded during the period in which they occur (Spiceland et. al., p. 7). Under the cash basis accounting method, the revenue is recognized when the cash is received and the expense is recognized when the cash is disbursed. “Cash-basis accounting does not recognize promises to pay or expectations to receive money or service in the future, such as payables, receivables, and prepaid expenses” (Wikimedia Foundation, Inc.). In addition, there is no inventory account under the cash basis method. Goods and materials purchased for sale are recorded as direct costs in the period that payment is made for those goods and materials (Berry).
Cash basis accounting is a simple and inexpensive method to implement and utilize. It also provides an accurate representation of cash flow. Additionally, the cash basis method provides the opportunity to “defer taxable income by delaying billing so that payment is not received in the current year…
Cash basis accounting does not comply with two important accounting principles: the revenue recognition principle and the matching principle. The revenue recognition principle requires that revenue be recognized when earned, not when the cash is received. The matching principle requires that expenses be matched against the related revenues, not at the time the cash is paid.
Since the cash basis technique does not recognize receivables or payables, it is not an accurate method of measuring profit (Nelson). It may appear that the company is earning a profit when in fact the company is losing money. It is extremely difficult to determine the actual profit or loss, because cash basis accounting does not acknowledge money that is due or money that is owed.
Accrual Basis Accounting
Accrual basis accounting is the method in which revenue is recognized when earned, and expenses are recognized when incurred. Additional accounts must be created to record the difference between the recognition of revenue or expenses and the receipt or disbursement of cash.
When revenue is recognized before cash is received, it is recorded in an accrued revenue account, such as accounts receivable. When revenue is recognized after cash has been received, it is recorded in a deferred revenue account, such as unearned revenue. When an expense is recognized before cash is paid, it is recorded in an accrued expense account, such as accounts payable. When an expense is recognized after cash has been paid, it is recorded in a deferred expense account, such as prepaid expense (Author Unknown). In addition, the inventory account is used under the accrual basis method. Goods and materials purchased for sale are recorded as current assets, and cost of goods sold are recorded in the period that the goods are actually sold (Berry).
One disadvantage of accrual basis accounting is that it is more complicated and expensive to implement and employ than the cash basis method. Another disadvantage to using the accrual basis method is that the company may owe taxes on revenue before payment is actually received. However, accrual basis accounting “provides a more accurate picture of how a business is performing over the long-term than the cash method” (Thomson Gale). In addition, due to compliance with the revenue recognition and matching principles, accrual basis accounting is a much more accurate method of measuring profit (Nelson).
Conclusion
“The U.S. Securities and Exchange Commission requires that all publicly traded companies follow GAAP, thus all publicly traded companies publish their financial statements using accrual-basis method” (Wikimedia Foundation, Inc.). The accrual basis is also “required for all businesses that handle inventory” (Thomson Gale). If the accrual basis method is used, it must be used for all financial reporting purposes. However, those that operate multiple businesses may use different accounting methods for each business.
Additionally, businesses may keep one set of books for financial reporting purposes and another set of books for tax purposes. Typically, businesses want to use cash accounting for tax reporting if they can, because cash accounting usually defers income taxes” (Nelson). The IRS generally requires all businesses to use the accrual basis of accounting on their tax returns, but the IRS does allow the use of the cash basis if certain criteria are met. Since tax laws change frequently, a tax accountant should be consulted prior to deciding to use the cash basis method for IRS tax reporting purposes.
References
Author Unknown. “Accrual Basis vs. Cash Basis Accounting.” Accounting Study Guide. URL: (http://accountinginfo.com/study/accrual-101.htm); Tim Berry. “Accrual Accounting is Standard. Cash Basis is Optional.” Tim Berry, Business Planning Expert. URL: (http://www.timberry.com/fm/Accrual_Accounting_is_Standard.htm); Stephen L. Nelson. “Accrual Basis Accounting vs. Cash Basis Accounting. Redmond & Bellevue. URL: (http://www.stephenlnelson.com/accrual_basis_vs_cash_basis_accounting.htm); Thomson Gale. “Cash vs. Accrual Basis”. Accounting Methods. URL: (http://www.referenceforbusiness.com/small/A-Bo/Accounting-Methods.html); Wikimedia foundation, Inc. “Accounting Methods”. Wikipedia. URL: (http://en.wikipedia.org/wiki/Accrual_basis_accounting).
