Accounting methods

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Cash basis

Cash-basis accounting is a method of bookkeeping that records financial events based on cash flows and cash position. Revenue is recognized when cash is received and expense is recognized when cash is paid. In cash-basis accounting, revenues and expenses are also called cash receipts and cash payments.

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.

This is simpler for individuals and organizations that do not have significant amounts of these transactions, or when the time lag between the initiation of the transaction and the cash flow is very short.

Two types of cash-basis accounting exist: strict and modified. Strict cash-basis follows the cash flow exactly. Modified cash-basis includes some elements from accrual-basis accounting such as inventory and property capitalization.

Issues with cash basis

Cash-basis accounting fails to meet GAAP requirements because it does not adhere to the following two GAAP principles:

• Revenue recognition principle - revenue should be recognized when it is realized (e.g. a credit sale)
• Matching principle - revenue should be matched to the expense if possible (e.g. sales to COGS)

Additionally, cash-basis accounting is not viable for cost accounting in manufacturing operations because expenses cannot always be correctly associated with product costs.

Example

When you pay your rent, your landlord would record an income event at the time he receives your payment. The landlord would subsequently record an expense event when he pays the rental agent their fee for your apartment. It is the accounting method used by most individuals, and by some businesses, that have limited payables or receivables or whose income and expense cash flows are closely associated with each other in time.

A simplified Income Statement and Balance Sheet for cash basis accounting might look like the following:

           Vandalay Industries            Income Statement   For the year ended December 31, 2004Revenue ............................ $1,000Expense ............................ $  800Net income ......................... $  200

            Vandalay Industries              Balance Sheet   For the year ended December 31, 2004Assets Cash .............................. $5,500  Total assets ..................... $5,500Liabilities and Stockholders' Equity Common stock ...................... $5,500  Total liabilities and Equity ..... $5,500

Accrual basis

Accrual-basis accounting records financial events based on events that change your net worth (the amount owed to you minus the amount you owe others). Standard practice is to record and recognize revenues in the period in which they incur and to match them with related expenses in a process known as matching or expense matching. Even though cash is not received or paid in a credit transaction, they are recorded because they are consequential in the future income and cash flow of the company. Accrual-basis is GAAP compliant.

Example

Your landlord would record an income event on the day your rent comes due (you owe it to him). He records an expense event when the fee owed to the rental agent comes due for your apartment that month (he owes it to the agent). The details of the actual cash flows and their timing are tracked by bookkeeping.

A simplified Income Statement and Balance Sheet for accrual basis accounting will look like the following (note the existence of receivable and payable):

           Vandalay Industries            Income Statement   For the year ended December 31, 2004Revenues ........................... $1,200Expenses ........................... $  800Net income ......................... $  400

           Vandalay Industries              Balance Sheet   For the year ended December 31, 2004Assets Cash .............................. $5,500 Accounts receivable ............... $  200  Total assets ..................... $5,700Liabilities and Stockholders' Equity Accounts payable .................. $  100 Common stock ...................... $5,600  Total liabilities and Equity ..... $5,700

Comparison

• Using cash-basis accounting, income and expenses are recognized only when cash is received or paid out.
• Using accrual-basis accounting, receivables and payables are recognized when a sale is agreed to, even though as yet, no cash has been received or paid out.
• Cash-basis accounting defers all credit transactions to a later date. It is more conservative for the seller in that it does not record revenue until cash receipt. In a growing company, this results in a lower income compared to accrual-basis accounting.

A simple example

• A small business such as a fruit stand, which buys its inventory daily for cash at a wholesale market, sells the inventory for cash, and throws away what didn't sell, can get an accurate picture of its profits or losses using cash-basis accounting.
• A remodeling business that gives customers 90 days to pay and that procures materials on account at the lumber yard, must use the accrual method to gain an accurate picture of its financial condition.
• Either business will probably get a relatively accurate picture using either method over a long period of time, except for the transactions that have already begun that are not yet closed.

Other considerations

Standard accrual-basis financial statements (profit statements and balance sheets) do not indicate the cash inflows and outflows of a company. The Statement of Cash Flows is created to indicate that information for accrual-basis accounting.

Accrual-basis accounting is more costly to maintain, because it requires the bookkeeper to record many more transactions. However, the advent of accounting software has made the difference between the reporting methods less significant.

Companies that have extended or used credit significantly should use (and in the United States may be required by the Internal Revenue Service to use) the accrual-basis method of accounting. 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. Three kind of external stakeholders should be considered when deciding the reporting method:

• creditors
• stockholders
• taxation authorities

For the creditors and stockholders of large enterprises, cash basis accounting is financially inadequate. It does not project the future cash flow of the company.

For tax purposes, cash basis accounting is highly favored because it defers tax burdens until the cash is received. It is often used by small businesses and organizations that are not required to use the accrual method, both for tax reasons and for its simplicity.