Which method of accounting recognizes revenue or income when cash is received and recognizes expenses when cash is paid?

4 Min. Read

March 28, 2019

Accrual basis and cash basis are two methods of accounting used to record transactions.

The key difference between the two methods is the timing in which the transaction is recorded. Over time, the results of the two methods are approximately the same.

Here is a brief overview of both methods:

Accrual Basis: The transaction and revenue are recorded when earned and expenses are recorded when consumed.

Cash Basis: The transaction and revenue are recorded when cash is received from customers. Expenses are recorded when cash is paid to suppliers and employees.

As per the IRS regulations, the cash basis method is only available if a company has no more than $5 million in sales per year. Cash basis is the easiest accounting method for recording transactions because no complex accounting transaction such as accrual and deferrals are needed. This method is widely used in small businesses because it is so easy to use. However, the random timing of cash receipts and expenditures means that results reported can vary between unusually high and low profits

Although the IRS requires (and can only audit) all companies with sales exceeding over $5 million dollars, there are other reasons larger companies use the accrual basis method to record their transactions. Under accrual accounting, financial results of a business are more likely to match revenues and expenses in the same reporting period, so that the true profitability of a business can be recognized. Unless a statement of cash flow is included in the company’s financial statements, this approach does not reveal the company’s ability to generate cash.

This article will also include information on:

What Is the Main Difference Between Cash and Accrual Accounting?

What Is Better Cash or Accrual Accounting?

NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.

What Is the Main Difference Between Cash and Accrual Accounting?

The main difference between accrual and cash basis accounting is the timing of when revenue and expenses are recorded and recognized. Cash basis method is more immediate in recognizing revenue and expenses, while the accrual basis method of accounting focuses on anticipated revenue and expenses.

Here are some examples that apply these concepts:

Revenue Recognition

A company sells $20,000 of product to a customer in August. The customer pays that invoice in September. With the cash basis method, the company recognizes the sale in September, when cash is received. Whereas with the accrual basis accounting, the company recognizes the sale in August, when it is issued the invoice.

Expense Recognition

A company buys $700 of office supplies in March, which it pays for in April. With the cash basis method, the company recognizes the purchase in April, when it pays the bill. Whereas with the accrual basis accounting, the company recognizes the purchase in March, when it received the supplier invoice.

What Is Better Cash or Accrual Accounting?

Both accrual and cash basis accounting methods have their advantages and disadvantages but neither shows the full picture about a company’s financial health. Although, accrual method is the most commonly used by companies, especially publicly traded companies. A reason for the accrual basis method of accounting popularity is that it levels out earnings overtime since it records all revenue and expenses as they’re generated instead of being recorded sporadically like they are under the cash basis method.

Here are the advantages and disadvantages of both accounting methods.

Cash Basis Accounting Method

Accrual Basis Accounting Method

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In the previous section, you learned the first column of the accounting cycle.  Now we will finish the remainder of the accounting cycle.  The complete cycle is:

Before we can prepare adjusting journal entries, we need to understand a little more theory.

Revenue Recognition

Revenue is not difficult to define or measure; it is the inflow of assets from the sale of goods and services to customers, measured by the cash expected to be received from customers. However, the crucial question for the accountant is when to record a revenue. Under the revenue recognition principle, revenues should be earned and realized before they are recognized (recorded).

Matching Principle

Expense recognition is closely related to, and sometimes discussed as part of, the revenue recognition principle. The matching principle states that expenses should be recognized (recorded) as they are incurred to produce revenues. An expense is the outflow or using up of assets in the generation of revenue.

CASH VERSUS ACCRUAL BASIS ACCOUNTING

Professionals such as physicians and lawyers and some relatively small businesses may account for their revenues and expenses on a cash basis. The cash basis of accounting recognizes revenues when cash is received and recognizes expenses when cash is paid out. For example,  a company could perform work in one year and not receive payment until the following year.  Under the cash basis, the revenue would not be reported in the year the work was done but in the following year when the cash is actually received.

Because the cash basis of accounting does not match expenses incurred and revenues earned in the appropriate year, it does not follow Generally Accepted Accounting Principles (GAAP). The cash basis is acceptable in practice only under those circumstances when it approximates the results that a company could obtain under the accrual basis of accounting. Companies using the cash basis do not have to prepare any adjusting entries unless they discover they have made a mistake in preparing an entry during the accounting period.

Most companies use the accrual basis of accounting. The accrual basis of accounting recognizes revenues when earned (a product is sold or a service has been performed), regardless of when cash is received. Expenses are recognized as incurred, whether or not cash has been paid out. For instance, assume a company performs services for a customer on account. Although the company has received no cash, the revenue is recorded at the time the company performs the service. Later, when the company receives the cash, no revenue is recorded because the company has already recorded the revenue. Under the accrual basis, adjusting entries are needed to bring the accounts up to date for unrecorded economic activity that has taken place.

The following video summarizes the difference between cash and accrual basis of accounting.

Throughout the text we will use the accrual basis of accounting, which matches expenses incurred and revenues earned, because most companies use the accrual basis.

Time-Period Assumption

According to the periodicity (time periods) assumption, accountants divide an entity’s life into months or years to report its economic activities. Then, accountants attempt to prepare accurate reports on the entity’s activities for these periods. Although these time-period reports provide useful and timely financial information for investors and creditors, they may be inaccurate for some of these time periods because accountants must estimate depreciation expense and certain other adjusting entries.

Accounting reports cover relatively short periods. These time periods are usually of equal length so that statement users can make valid comparisons of a company’s performance from period to period. The length of the accounting period must be stated in the financial statements. For instance, so far, the income statements in this text were for either one month or one year. Companies that publish their financial statements, such as publicly held corporations, generally prepare monthly statements for internal management and publish financial statements quarterly and annually for external statement users.

Accrual basis and periodicity

Previously, we demonstrated that financial statements more accurately reflect the financial status and operations of a company when prepared under the accrual basis rather than the cash basis of accounting. The periodicity assumption requires preparing adjusting entries under the accrual basis. Without the periodicity assumption, a business would have only one time period running from its inception to its termination. Then, the concepts of cash basis and accrual basis accounting would be irrelevant because all revenues and all expenses would be recorded in that one time period and would not have to be assigned to artificially short periods of one year or less.