Cash‐Basis Accounting Versus Accrual‐Basis Accounting
LEARNING OBJECTIVE *6
Differentiate the cash basis of accounting from the accrual basis of accounting.
Most companies use accrual‐basis accounting: They recognize revenue when the performance obligation is satisfied and expenses in the period incurred, without regard to the time of receipt or payment of cash.
Some small companies and the average individual taxpayer, however, use a strict or modified cash‐basis approach. Under the strict cash basis, companies record revenue only when they receive cash, and they record expenses only when they disperse cash. Determining income on the cash basis rests upon collecting revenue and paying expenses. The cash basis ignores two principles: the revenue recognition principle and the expense recognition principle. Consequently, cash‐basis financial statements are not in conformity with IFRS.
An illustration will help clarify the differences between accrual‐basis and cash‐basis accounting. Assume that Eser Contractor signs an agreement to construct a garage for 22,000. In January, Eser begins construction, incurs costs of 18,000 on credit, and by the end of January delivers a finished garage to the buyer. In February, Eser collects 22,000 cash from the customer. In March, Eser pays the 18,000 due the creditors. Illustrations 3A‐1 and 3A‐2 show the net incomes for each month under cash‐basis accounting and accrual‐basis accounting, respectively.
ILLUSTRATION 3A‐1 Income Statement—Cash Basis
ESER CONTRACTOR INCOME STATEMENT—CASH BASIS
FOR THE MONTH OF
January February March Total
Cash receipts –0– 22,000 –0– 22,000
Cash payments –0– –0– 18,000 18,000
Net income (loss) –0– 22,000 (18,000) 4,000
ILLUSTRATION 3A‐2 Income Statement—Accrual Basis
ESER CONTRACTOR
INCOME STATEMENT—ACCRUAL BASIS FOR THE MONTH OF
January February March Total
Revenues 22,000 –0– –0– 22,000
Expenses 18,000 –0– –0– 18,000
Net income (loss) 4,000 –0– –0– 4,000
For the three months combined, total net income is the same under both cash‐basis accounting and accrual‐basis accounting. The difference is in the timing of revenues and expenses. The basis of accounting also affects the statement of financial position.
Illustrations 3A‐3 and 3A‐4 show Eser's statements of financial position at each month‐end under the cash basis and the accrual basis.
ILLUSTRATION 3A‐3 Statements of Financial Position—Cash Basis
ESER CONTRACTOR
STATEMENTS OF FINANCIAL POSITION—CASH BASIS AS OF
January 31 February 28 March 31 Assets
Cash –0– 22,000 4,000
Total assets –0– 22,000 4,000
Equity and liabilities
Equity –0– 22,000 4,000
Total equity and liabilities –0– 22,000 4,000
ILLUSTRATION 3A‐4 Statements of Financial Position—Accrual Basis
ESER CONTRACTOR
STATEMENTS OF FINANCIAL POSITION—ACCRUAL BASIS AS OF
January 31 February 28 March 31 Assets
Accounts receivable 22,000 –0– –0–
Cash –0– 22,000 4,000
Total assets 22,000 22,000 4,000
Equity and liabilities
Equity 4,000 4,000 4,000
Accounts payable 18,000 18,000 –0–
Total equity and liabilities 22,000 22,000 4,000
Analysis of Eser's income statements and statements of financial position shows the ways in which cash‐basis accounting is inconsistent with basic accounting theory:
1. The cash basis understates revenues and assets from the construction and delivery of the garage in January. It ignores the 22,000 of accounts receivable,
representing a near‐term future cash inflow.
2. The cash basis understates expenses incurred with the construction of the garage and the liability outstanding at the end of January. It ignores the 18,000 of
accounts payable, representing a near‐term future cash outflow.
3. The cash basis understates equity in January by not recognizing the revenues and the asset until February. It also overstates equity in February by not recognizing the expenses and the liability until March.
In short, cash‐basis accounting violates the accrual concept underlying financial reporting.
The modified cash basis is a mixture of the cash basis and the accrual basis. It is based on the strict cash basis but with modifications that have substantial support, such as capitalizing and depreciating plant assets or recording inventory. This method is often followed by professional services firms (doctors, lawyers, accountants,
consultants) and by retail, real estate, and agricultural operations.1
Conversion from Cash Basis to Accrual Basis
Not infrequently, companies want to convert a cash basis or a modified cash basis set of financial statements to the accrual basis for presentation to investors and creditors.
To illustrate this conversion, assume that Dr. L. Liwan, like many small business owners, keeps her accounting records on a cash basis. In the year 2019, Dr. Liwan received 300,000 from her patients and paid 170,000 for operating expenses, resulting in an excess of cash receipts over disbursements of 130,000 ( 300,000 −
170,000). At January 1 and December 31, 2019, she has accounts receivable, unearned service revenue, accrued liabilities, and prepaid expenses as shown in Illustration 3A‐5.
ILLUSTRATION 3A‐5 Financial Information Related to Dr. L. Liwan
January 1, 2019 December 31, 2019
Accounts receivable 12,000 9,000
Unearned service revenue –0– 4,000
Accrued liabilities 2,000 5,500
Prepaid expenses 1,800 2,700
Service Revenue Computation
To convert the amount of cash received from patients to service revenue on an accrual basis, we must consider changes in accounts receivable and unearned service revenue during the year. Accounts receivable at the beginning of the year represents revenues that are collected this year. Ending accounts receivable indicates revenues that are not yet collected. Therefore, to compute revenue on an accrual basis, we subtract beginning accounts receivable and add ending accounts receivable, as the formula in Illustration 3A‐6 shows.
ILLUSTRATION 3A‐6 Conversion of Cash Receipts to Revenue—Accounts Receivable Cash Receiptsfrom Customers{−Beginning Accounts Receivable+Ending Accounts
Receivable}=Revenueon anAccrual Basis
Similarly, beginning unearned service revenue represents cash received last year for services to be performed this year. Ending unearned service revenue results from collections this year for services to be performed next year. Therefore, to compute revenue on an accrual basis, we add beginning unearned service revenue and
subtract ending unearned service revenue, as the formula in Illustration 3A‐7 shows.
ILLUSTRATION 3A‐7 Conversion of Cash Receipts to Revenue—Unearned Service Revenue
Cash Receiptsfrom Customers{+Beginning Unearned Service Revenue−Ending Unearned Service Revenue}=Revenueon anAccrual Basis
Therefore, for Dr. Liwan's dental practice, to convert cash collected from customers to service revenue on an accrual basis, we would make the computations shown in Illustration 3A‐8.
ILLUSTRATION 3A‐8 Conversion of Cash Receipts to Service Revenue
Cash receipts from customers 300,000
− Beginning accounts receivable (12,000) + Ending accounts receivable 9,000 + Beginning unearned service revenue –0–
− Ending unearned service revenue (4,000) (7,000)
Service revenue (accrual) 293,000
Operating Expense Computation
To convert cash paid for operating expenses during the year to operating expenses on an accrual basis, we must consider changes in prepaid expenses and accrued
liabilities. First, we need to recognize as this year's expenses the amount of beginning prepaid expenses. (The cash payment for these occurred last year.) Therefore, to arrive at operating expense on an accrual basis, we add the beginning prepaid expenses balance to cash paid for operating expenses.
Conversely, ending prepaid expenses result from cash payments made this year for expenses to be reported next year. (Under the accrual basis, Dr. Liwan would have deferred recognizing these payments as expenses until a future period.) To convert these cash payments to operating expenses on an accrual basis, we deduct ending prepaid expenses from cash paid for expenses, as the formula in Illustration 3A‐9 shows.
ILLUSTRATION 3A‐9 Conversion of Cash Payments to Expenses—Prepaid Expenses Cash Paid forOperating Expenses{+Beginning Prepaid Expenses−Ending Prepaid
Expenses}=Expenseson anAccrual Basis
Similarly, beginning accrued liabilities result from expenses that require cash
payments this year. Ending accrued liabilities relate to expenses recognized this year that have not been paid. To arrive at expense on an accrual basis, we deduct
beginning accrued liabilities and add ending accrued liabilities to cash paid for expenses, as the formula in Illustration 3A‐10 shows.
ILLUSTRATION 3A‐10 Conversion of Cash Payments to Expenses—Accrued Liabilities Cash Paid forOperating Expenses{−Beginning Accrued Liabilities+Ending Accrued
Liabillities}=Expenseson anAccrual Basis
Therefore, for Dr. Liwan's dental practice, to convert cash paid for operating expenses to operating expenses on an accrual basis, we would make the computations shown in Illustration 3A‐11.
ILLUSTRATION 3A‐11 Conversion of Cash Paid to Operating Expenses Cash paid for operating expenses 170,000 + Beginning prepaid expense 1,800
− Ending prepaid expense (2,700)
− Beginning accrued liabilities (2,000)
+ Ending accrued liabilities 5,500 2,600 Operating expenses (accrual) 172,600
This entire conversion can be completed in worksheet form, as shown in Illustration 3A‐12.
ILLUSTRATION 3A‐12 Conversion of Statement of Cash Receipts and Disbursements to Income Statement
Using this approach, we adjust collections and disbursements on a cash basis to revenue and expense on an accrual basis, to arrive at accrual net income. In any conversion from the cash basis to the accrual basis, depreciation or amortization is an additional expense in arriving at net income on an accrual basis.
Theoretical Weaknesses of the Cash Basis
The cash basis reports exactly when cash is received and when cash is disbursed. To many people that information represents something concrete. Isn't cash what it is all about? Does it make sense to invent something, design it, produce it, market and sell it, if you aren't going to get cash for it in the end? Many frequently say, “Cash is the real bottom line,” and also, “Cash is the oil that lubricates the economy.” If so, then what is the merit of accrual accounting?
Today's economy is considerably more lubricated by credit than by cash. The accrual basis, not the cash basis, recognizes all aspects of the credit phenomenon. Investors, creditors, and other decision‐makers seek timely information about a company's future cash flows. Accrual‐basis accounting provides this information by reporting the cash inflows and outflows associated with earnings activities as soon as these companies can estimate these cash flows with an acceptable degree of certainty. Receivables and payables are forecasters of future cash inflows and outflows. In other words, accrual‐basis accounting aids in predicting future cash flows by reporting transactions
and other events with cash consequences at the time the transactions and events occur, rather than when the cash is received and paid.