As part time CFO I constantly get asked the question as to what the difference is between the cash and accrual basis of accounting. For those of you who are QuickBooks users you probably know that QuickBooks (thru the "Modify Report" Button) provides the user with the option of reporting financial statements under either cash or accrual reporting basis. Many times my clients see a significant discrepancy in their profit and wonder why. One of my CFO Services is to explain to the client the difference between the cash and accrual reporting basis.
Under the Accrual Reporting Basis revenues are recognized in the month the product is sold or the service is performed whether the cash on the sale is received or not. To give you an example, if you sell computers and the computer is shipped to the customer in the month of May with 60 day terms. Under the accrual basis the sale will be recognized in May and not 60 days later in July when the cash is received. Under the Accrual Reporting Basis expenses are recognized when incurred and are not recognized when paid. For example, if part of your cost to produce the computers you built and shipped in May were to hire outside contracted labor with 30 day terms the expense would be recorded in May even though you paid for the contracted labor in June.
Under the Cash Reporting Basis revenues are recognized in the month the product is paid for by the customer and not in the month when the product was shipped to the customer. Going back to the computer example the computer is shipped to the customer in the month of May with 60 day terms. Under the cash basis the sale will be recognized in July when the product is paid for, not in May when the product was shipped. Under the Cash Reporting Basis expenses are recognized when paid and are not recognized when incurred. For example, if part of your cost to produce the computers you built and shipped in May were to hire outside contracted labor with 30 day terms the expense would be recorded when you paid the expense in June and not when you incurred the expense in May.
So which is method is better? For income tax purposes both methods of accounting are allowed and you should consult an income tax professional to find out. For management purposes, in my view the accrual basis of accounting is better hands down. The accrual basis is better because it provides a more accurate matching of expenses with revenues. Taking a look at the computer company example under the Accrual method the product is shipped in May and revenue is recognized. The expense associated with the product (outside contractors) is recognized in May when incurred. This is a perfect match of revenues with the expenses that produced that revenue. Now take a look at the same example under the cash basis. The revenue would be recognized when paid in July and the expense would be recognized when paid in June. There you have an obvious mismatching of revenues and expenses.
Through utilization of the accrual basis and the proper matching of revenues with expenses more useable management reports are available and in turn better decision making. Certainly the CFO as well as the business owner will be able to better utilize and make more effective judgments with the accrual basis of accounting. As previously mentioned the IRS allows for both methods of accounting however under GAAP (Generally Accepted Accounting Principles) only the accrual reporting basis of accounting is allowed.