Difference between cash basis and accrual basis
When it comes to recording transactions of a business in books, the two most commonly used methods include cash and accrual basis of accounting. While the former records transactions based on cash inflow and outflow, the latter stresses on recognition of income and expense. Let us see how do they differ.
Cash basis of accounting
Cash basis of accounting is a method of recording transactions in which revenue, costs, assets, and liabilities are reflected in the books of account for the period in which actual receipts or actual payments are made.
Transactions are documented in books as soon as there is an exchange of cash. Thus, expenses are recorded when cash is paid for them and incomes are recorded when cash is received. When a payment or receipt is simply due, no entry is made.
This method does not consider any revenue to have been earned or any sales to have occurred unless cash is received from customers. Furthermore, it makes no difference whether the receipts are from a previous or future period. As long as cash is received, it gets recorded in that period itself.
Similarly, expenses are confined to actual payments in cash made during the current year, regardless of whether the payments were made for a previous or future period.
Accrual basis of accounting
On the other hand, the accrual basis of accounting is a method of recording transactions in which revenue, costs, assets, and liabilities are reflected in the books of account for the period in which they accrue. It is also called the mercantile basis of accounting.
All companies are required to maintain their books of account according to an accrual basis as per the Companies Act 2013. (Section 128)
In this method, income is recognized when it is earned rather than when it is received in cash. Similarly, expenses are recorded when they are incurred rather than when they are paid.
It asserts that buying, selling, and other economic activities of an enterprise do not always coincide with the cash receipts and payments. It is not necessary that there is an immediate settlement in cash for every transaction or event. Therefore, it is important to relate the revenue earned to the cost incurred so that net income reported in a period measures the enterprise’s performance during that period instead of merely listing its cash receipts and payments.
Unlike cash basis, the accrual basis of accounting takes into consideration deferrals, allocations, depreciation, and amortization. Let us see some examples of these.
Accrued Expenses or Outstanding Expenses
There could be expenses incurred for the current period, but not paid for. The matching principle in accounting requires that this expense be recognized as an expense for the current year and not deferred until its actual payment.
For example, we all know that salary for a month is usually paid in the first week of the following month. Assume the fiscal period ends on 31st March. The salary for March is not paid until the 31st of March. However, because it is related to this month, it must be recorded as an expense for this month as well as a liability payable in the following month (which is in next year).
The entry for this is:
Salary A/c Dr.
To Outstanding Salary A/c or Expense payable A/c
This way March month’s salary will get recorded in the current fiscal year only. Therefore, in the accrual system, outstanding expenses are added to Respective Expense A/c in P & L A/c and also shown as a liability in the Balance Sheet.
Prepaid Expenses
Sometimes, we may have to pay for certain period-related expenses from time to time. For example, suppose a company has purchased a fire insurance policy with an annual premium of $7,500. The policy is effective on January 1st and is valid until December 31st. However, the company’s fiscal year ends on March 31st. What amount should be considered when calculating the insurance expense for the fiscal year?
Here, only three months of the total premium period of twelve months are related to the current accounting period, while the remaining nine months are related to the next accounting period. As a result, only three months’ premium, or $1,875 (7,500 ÷ 4), should be considered as an expense for the current year.
The entry for this is:
Prepaid Expense A/c Dr.
To Expense A/c
Thus, when following an accrual system, the prepaid amount of $5,625 must be reduced from the respective expense in P & L A/c and shown as an asset in the Balance Sheet.
Accrued Income
Another item that needs special consideration in the accrual method is “accrued income”. At the end of an accounting period, income is accrued in the same way that expenses are. It must be recorded as income in the current accounting period to the extent that it accrues.
Assume a company places a one-year fixed deposit of $100,000 with a bank at a fixed interest rate of 9% p.a. on 1st February 2021, and the interest is credited by the bank semi-annually. Also, keep in mind that the fiscal year ends on March 31, 2021. The first semi-annual interest will be credited by the bank on July 31, 2021, and the second on January 31, 2022.
It is worth noting here that $1,500 interest for two months (Feb & Mar 2021) will be considered accrued as of March 31, 2021, and must be included in income for the current fiscal year.
The entry for this is:
Accrued Interest A/c Dr.
To Interest A/c
Thus, accrued income must be shown as income in the P & L A/c and also as an asset in the Balance Sheet.
Income Received in Advance
Under the accrual system, if an income is received which is not related to the current period, it cannot be included in the current year’s P & L statement. So, if it’s already included as an income, it must be reduced.
The entry for this is:
Respective Income A/c Dr.
To Income received in advance A/c
It must be reduced from respective income and shown as a liability in the Balance Sheet.
Did you know? There is another system of accounting called hybrid or mixed basis. Under the hybrid system, incomes are recognized on a cash basis, i.e., when they are received in cash, and expenses are recognized on an accrual basis, i.e., during the period in which they arise irrespective of when they are paid.
Comparison flowchart – Difference between cash basis and accrual basis
1. Prepaid & Outstanding Expenses/Accrued & Unaccrued Income
| Under a cash basis, there is no expense/income recognized as prepaid, outstanding, receivable, or received in advance. Hence, such items do not appear in the Balance Sheet. | Under the accrual basis, there may be prepaid or outstanding expenses and accrued/unaccrued incomes in the Balance Sheet. Prepaid expenses and income receivable are shown on the asset side while outstanding expenses and income received in advance are shown on the liability side. |
2. In case of prepaid expenses and accrued income
| On a cash basis, the income statement will show a lower income. | On an accrual basis, the income statement will show a relatively higher income. Since prepaid expenses are related to the next year, they are excluded from the income statement. Similarly, accrued income is included while determining profit as it pertains to the current year. |
3. In case of outstanding expenses and income received in advance
| The income statement will show a higher income under the cash basis of accounting. | Under the accrual basis, the income statement will show a relatively lower income. Outstanding expenses, though not paid, relate to the current year. Hence, they are included on the expense side of P & L. Similarly, income received in advance is excluded from the income statement as it relates to the next accounting period. |
4. Recognition under Companies Act 2013
| The cash basis of accounting is not recognized in the Companies Act. | Accrual basis is recognized in the Companies Act. |
5. Matching principle
| The cash system of accounting is incompatible with the matching concept. Thus, financial statements prepared under this system do not give a true and fair view of the operating results and financial position of a company. | Under the accrual system, costs are matched against revenues based on the relevant period to determine periodic income or loss. Therefore, it portrays an accurate picture of a company’s health by including receivables and payables. |
6. Income measurement
| Under the cash basis, income is measured as a difference between cash receipts and cash disbursements. | In the accrual basis of accounting, income is measured as a difference between revenues and expenses. |
7. Ease
| The cash basis of accounting is easier. | The accrual method requires more work on cost and revenue allocation. |
Conclusion
The primary distinction between accrual and cash basis of accounting is the timing of revenue and expense recognition. The cash method recognizes revenue and expenses more quickly, whereas the accrual method focuses on anticipated revenue and expenses.
Cash accounting is generally suitable where the business is very small or in the case of individuals, where it is difficult to divide small amounts between accounting periods. Rest in all the cases, the accrual method is the most commonly used since it depicts accurate earnings over time.
Hope the information provided in this blog proves helpful to you!
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