3 Introduction to accounting

3.2 Cash versus accrual basis

Financial statements, such as the Income Statement and Balance Sheet can be prepared using either a cash or accrual basis.

In cash basis accounting, the income is deemed earned when the business physically receives the customer payment, and the expenses are deemed incurred when the business physically pays them. Cash basis accounting does not require the use of purchase orders, invoices, or long term liabilities.

In accrual basis accounting, income is considered earned when a valid asset is received for services or product provided. The asset is the claim on the customer, by way of the invoice, to collect an amount at a later date. This asset is called Accounts Receivable. An expenses is considered earned when a liability is created, by way of a purchase order, to the supplier or vendor. The liability is the commitment to pay the supplier or vendor at a later date. This liability is called Accounts Payable. Accrual basis accounting requires the use of invoices and purchase orders.

There can be a number of problems with cash basis accounting:

  • No visibility in the accounting system regarding your cash commitments leading you to think you have more or less money to spend than you actually have.

  • No visibility in the accounting system about unpaid customer debts.

  • Your taxing jurisdiction may limit businesses that can use cash basis accounting. For example in the United States, if you sell products or services on credit, have gross receipts higher that allowed, or need inventory to account for income.

  • Because cash basis accounting isn’t part of any accounting standards, there are varying expectations of what a cash balance or income statement looks like.