Accrual Accounting vs. Cash Basis Accounting: Videos & Practice Problems

Accrual-basis accounting, required by GAAP, records transactions when they occur, ensuring accurate financial reporting through journal entries for revenues and expenses, even if cash hasn't moved. In contrast, cash-basis accounting only recognizes transactions when cash is exchanged, making it simpler but less comprehensive. This distinction affects how companies report their financial position, with accrual accounting providing a clearer picture of liabilities and revenues, such as accrued expenses for unpaid employee work. Understanding these differences is crucial for effective financial management and compliance with accounting standards.

Accrual Accounting

All right. So now let's consider the differences between an Accrual Basis of Accounting, which is what GAAP requires, and a Cash Basis of Accounting, which is generally just easier to use, but it doesn't follow GAAP. Okay? Let's check it out. So, the first thing, let's consider something. The only way for us to really know the worth of our company, for us to truly know the worth, we would have to liquidate the company, right? And liquidate, that means to sell all the assets, right? Any inventory we have, we just have to sell it off. Any machines we have for production, we sell them and just get all in cash, right? So, our only asset is cash, and then we pay off all our liabilities. Everybody that we owe money, the banks, our suppliers, and then whatever's left over, right? Whatever's left over is the company's worth, right? That's really the true way to know what the company is worth. But obviously, an ongoing company just can't liquidate, right? So what we do is we use these financial statements. They act as progress reports for the company. I'm going to use this thinner pen at, I think it reports. I think the thinner pen looks a little nicer. Okay. Progress reports. Right? So, the financial statements, they come out periodically, right? And that's what this time period concept has to do with. When we do accrual accounting, which is what GAAP requires. Well, in accrual accounting, we're going to report our accounting information at regular intervals, right? And these are going to be consistent. So generally, these are going to be yearly, right? Or monthly or quarterly, right? It's got to be some sort of consistent interval, and in this interval, we want to understand what happened during that interval, right? At the beginning, we'll have a balance sheet at the beginning of the interval that tells us the assets, liabilities, equity, right? That we have. And then the income statements telling us what happened throughout the interval, say throughout the year. And then at the end of the year, we'll have a new balance sheet showing the new position of the company, right? So that's the time period concept that we're dealing with in accrual accounting, right? But we're just breaking up the time into these years. But the time doesn't stop, right? It's just constantly going. So the reason we break it up is for the reporting process.

So, let's first think about accrual accounting. And remember, accrual accounting, this is GAAP. Okay? GAAP requires accrual accounting. So what does it mean? Well, accrual accounting records the impact of business transactions as they occur, okay? So there's going to be triggering events that make us make a journal entry or make some sort of record that this event occurred. Okay? So with accrual accounting, you're going to see that every time there's some sort of event, we're going to make a journal entry. And let's think about revenue as well. So when we make a cash sale in accrual accounting, Well, this was an event, right? We delivered our product, we did our job, we're going to make a journal entry, right? We're going to make a journal entry, I'm going to put JE for journal entry. And I'm also going to put revenue right here because we do earn revenue at this point. Same thing with a credit sale, right? Now this is what's going to be different from a cash basis. So notice here, in accrual accounting, when we make a credit sale, this means that we give the customer the product, but they didn't pay us yet, right? We let them pay us later on. We gave them say a month to pay. So when we make a journal entry and So we're going to make a journal entry and we're going to earn revenue in this case. Okay? Now how about when we receive the cash from that credit sale, right? We made this sale, let's say now a month ago, and now finally the customer is paying us. Well, now when the customer pays us, this isn't a revenue entry. We took the revenue for this when we gave the customer the product, right? Now it's just a cash collection. This has nothing to do with us earning the revenue, but we still make a journal entry. Okay? This journal entry, it's going to be about accounts receivable. Right? We have some account receivable, some money owed to us, and we're collecting that account receivable, right? So there's no revenue there, we're just collecting an account receivable.

How about when we pay our employees? When we make a payment to our employees, we're going to make a journal entry and generally this payment, well, it's going to get rid of the liability of the money we owe to the employees, right? There's money, the employees work for us and while they work for us, they're accumulating earnings, right? That we have to pay to them. So eventually, when we pay them, this is us finally paying them and getting rid of that liability that we have, right? We have this liability to pay these employees, so we're going to get rid of it, right? And this generally with employees expenses, we're going to get we're going to get to this a little more, and we'll deal with it in a little more detail. So you'll see more details about that later. But just the idea that when they work for us, we're going to get rid of this liability, right? Of us owing them money when we finally pay them. Okay? And the last but not least, this is another trick with accrual accounting. So think about when an employee works. Let's say they had a pay date on January 28th and they kept working the next 3 days of the month, January 29th, January 30, January 31. But we didn't pay them for those days yet, right? So we have to accrue an expense for those days when we're doing accrual accounting, right? Let's say we're going to report our income statement on January 31st. We last paid the employee on the 28th. Well, he did work for us those 3 days on the 29th, 30th, 31st, but we didn't account for it in this period, right? Because our last payment to them was the 28th, we made a journal entry on the 28th, but they kept working. So these 3 days, we actually have to make a journal entry here. And we're going to learn more about these journal entries to accrue this expense. Okay? For those 3 days. Even though we didn't pay any cash, right? They work for us those 3 days. The pay dates coming up someday in the future and we're going to have to pay them on that future date, right? But those 3 days that they work this month, we have to accrue that expense this month. Okay? So we go into a lot more details about all of that, throughout this unit, but I just want you to notice that we're all of these events are triggering for a journal entry. Right? We had to make cash basis. Cool? Alright. So let's pause and we'll continue the rest of the cash basis. Cool? Alright. So let's pause and we'll continue the rest of the sheet.

Cash Basis Accounting

Alright. So now let's consider those same transactions from a cash basis. Alright. I want to note real quick that this is not GAAP, okay? So this does not follow the required standards in the United States are GAAP, and this is not part of those standards. The reason we still study it and still learn it is because this is an easy model that's still used by a lot of businesses, especially small simple businesses. When I had my tutoring business, just doing private tutoring, well, I just used the cash basis of accounting, right? Because it wasn't so complicated. Whatever my customers paid me, well that's when I earned my revenue, okay? Because it was just a simple business. And that's the difference here is that everything in a cash basis is only impacted when cash is involved. Okay? So we only record the impact of cash transactions. Okay? So only when there's cash movement, will we make a journal entry. So when we make a cash sale? Yes. We're going to make a journal entry here and that is going to be revenue, right? So I did a tutoring session and the student paid me at the end of the session in cash. Boom. I make my journal entry. I earned my revenue. Now what about a student, he comes to me and I tutor him for 2 hours and then he's like, "Oh. Let me pay you next time." Alright? Well, in a cash basis of accounting, since he didn't give me the cash yet, we don't record revenue. There's actually no journal entry that's going to be made at this point. We're not going to credit an account or debit an accounts receivable or anything like that. There's nothing like that. We're not accruing anything in a cash basis. Right? Notice accrual accounting, we're accruing things like a receivable or a liability, things like that. Where in a cash basis, we don't make this journal entry for the credit sale. When we do make the journal entry is when we receive the cash. Notice, we're receiving the cash from that credit sale. Well, now, we make the journal entry to earn our revenue. Okay? Something that would be like we debit the cash and credit the revenue. Okay? And how about when we pay employees? When we pay the employees in cash, yes, we're paying them in cash, we're or excuse me, We're gonna make the journal entry. Right? And this will create an expense. We would do something like debiting wage expense and crediting cash, right? We credit cash to lower the balance, and debit the wage expense to increase the expense there. And the last one here with those 3 days at the end of the period, right? We were discussing that let's say the employee got paid on the 28th, but they also worked the 29th, 30th, and 31st of the month. And then we released our financial statements. Well from a cash basis, it doesn't matter. If the cash didn't move, there is no journal entry. We're not going to make any sort of accrual for those 3 days. So you can see how an accrual basis of accounting does a better job of matching all those expenses. Right? He worked those 3 days, well we're going to take the expense even though we didn't pay him in cash yet. Right? So that, that expense will show up on the income statement for those 3 days, and then we pay him in a later period. So that's the big thing about accrual accounting. Is that the movement of the cash doesn't dictate when we do rent, when we take revenue or expenses, right? It's when the benefit is transferred. So for revenue, when we deliver the product or complete the service for the customer, we take the revenue. Or for an expense, when we receive the benefit of what we're paying for or whatever we're getting, once we receive that, we gotta take the expense on that side. Right? From a cash basis, we just wait for the cash to move. So it's a lot easier in that sense. Alright? So that's about it for the accrual to cash basis of accounting. We'll also learn more about changing between cash and accrual, as we study adjusting entries. Okay? So let's go ahead and continue on to the next video.

Here’s what students ask on this topic:

What is the main difference between accrual accounting and cash basis accounting?

The main difference between accrual accounting and cash basis accounting lies in the timing of when transactions are recorded. Accrual accounting, required by GAAP, records revenues and expenses when they are earned or incurred, regardless of when cash is exchanged. This method provides a more accurate picture of a company's financial position by recognizing receivables and payables. In contrast, cash basis accounting only records transactions when cash is received or paid, making it simpler but less comprehensive. This method may not accurately reflect a company's financial health, as it ignores outstanding liabilities and receivables.

Why is accrual accounting required by GAAP?

Accrual accounting is required by GAAP because it provides a more accurate and comprehensive view of a company's financial position. By recording transactions when they occur, rather than when cash is exchanged, accrual accounting ensures that all revenues and expenses are matched to the period in which they are earned or incurred. This matching principle helps in presenting a true and fair view of the company's financial performance and position, which is crucial for stakeholders, including investors, creditors, and regulators, to make informed decisions.

How does accrual accounting handle credit sales?

In accrual accounting, credit sales are recorded when the sale occurs, not when the cash is received. When a product is delivered or a service is provided on credit, a journal entry is made to record the revenue and create an accounts receivable. This entry recognizes the revenue earned at the time of the sale. When the cash is eventually received from the customer, another journal entry is made to reduce the accounts receivable and increase cash, but no additional revenue is recorded at this point, as it was already recognized at the time of the sale.

What are the advantages of using cash basis accounting?

Cash basis accounting has several advantages, particularly for small and simple businesses. It is easier to implement and understand because it only records transactions when cash changes hands. This simplicity reduces the need for complex accounting systems and can lower administrative costs. Additionally, cash basis accounting provides a clear picture of cash flow, which can be beneficial for businesses that need to closely monitor their cash position. However, it may not provide a complete view of financial health, as it ignores receivables and payables.

How does accrual accounting handle employee expenses?

In accrual accounting, employee expenses are recorded when the employees earn their wages, not when they are paid. For example, if employees work at the end of a month but are paid in the following month, the company must accrue the expense for the days worked in the current month. This involves making a journal entry to recognize the wage expense and create a liability for the amount owed to employees. When the employees are eventually paid, another journal entry is made to reduce the liability and decrease cash.