The accrual and cash basis of accounting each affect income statement accounts differently due to the timing of recognition. Companies that follow guidelines for their financial statements published by the Financial Accounting Standards Board or the International Accounting Standards Board will follow the accrual basis of accounting. However, there is another method, and it may be more efficient and cost effective for companies not bound to the requirements put forth by the previously mentioned bodies.
Understanding the differences between cash and accrual methods of accounting hits the heart of financial reporting, and can extend to understanding how to switch between the two methods. Either method is allowable for internally generated financial reports, and when cash method is preferred for internal statements, but accrual is necessary for reporting purposes, understanding how the methods and how they may interchange is critically important.
There are accrual and deferral accounts that exemplify the importance of timing in the art of accounting. When a good or service is provided to a customer the accounts receivable account is used to recognize the event until the cash is received. Contrarily, the use of a good or service is recognized when the event occurs through the accounts payable account until the cash is paid.
The accrual method is clearly combative with the cash method in this example, because cash basis accounting would wait until the cash was received or paid to account for these events.
Recognition of the events as they occur mean we accrue for the measurement aspect of the transaction before cash received, and the opposite situation would result when we account for cash received before the event has occurred. These situations are referred to as a deferral account. Prepaid expenses and unearned revenue are the two categories of accounts that meet this situation of deferral.
It is understandable why a company would feel relieved to use cash basis accounting to avoid these accrual and deferral accounts. The cash basis method determines the timing and measurement of recognition based on the receipt of cash. For example, a vendor payment would not be recognized as an expense until the vendor was paid. As earlier explained, although companies may prefer to use cash basis ,Generally Accepted Accounting Principles, or the International Financial Reporting Standards do not permit this method of accounting.
Cash Basis v. Accrual Basis on Financial Statements
by Stephanie Carlozzi
Stephanie Carlozzi-Master's Degree in Accounting Student at Naveen Jindal School of Management
and is in the 2017 mentoring program at IAA CPA FIRM PLLC