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Student 1 post:

The two main types of accounting that businesses employ to keep track of their finances and for tax purposes is the cash basis and accrual basis of accounting. The major difference between these two bases of accounting is timing of revenue and expenses are recognized. The cash method is a more immediate recognition of revenue and expenses, while the accrual method focuses on anticipated revenue and expenses.

Typically, revenue is recorded before any money changes hands. Unfortunately, when utilizing the accrual method customers can receive products or services with the understanding that the money will be paid later. The expenses for those goods and services are recorded despite no cash was exchanged.

When it comes to the cash basis method revenue is recorded on the income statement once cash is received and expenses are recorded when cash is paid out. You see the cash method used by small businesses like Mom & Pop Stores and Smoke Shops, as well as for personal finances. The only advantage of using the cash basis method is its simple, it only accounts for cash paid or received, and it tracks the cash flow.

Both methods have their advantages and disadvantages, and each only shows part of the financial health of a firm. As a stakeholder you must understand both the methods to make an investment decision.

Revenue Transaction: Let’s say you own a roofing business. You charged your client $10,000 to replace their roof, under the cash method, that amount is not recorded in the books until the customer hands you the money or you receive the check. Under the accrual method, the $10,000 is recorded as revenue immediately when the sale is made, even if you receive the money a few days or weeks later.

Expense Transaction: The same principle applies to expenses. You receive your mortgage bill for $2,000, under the cash method the amount is not added to the income statement until you pay the bill. However, under the accrual method, the $2,000 is recorded as an expense the day you receive the bill.

 

References:

Edmonds, T., Edmonds, C., Edmonds, M., Edmonds, J., Olds, P. (2021). Survey of Accounting (6th ed.). N.p: McGraw-Hill Education

What is the Difference between Cash and Accrual Accounting? FreshBooks (Aug 20, 2021). Retrieved from https://www.freshbooks.com/hub/accounting/difference-between-cash-and-accrual-accounting.

Response:

Student 2 Post:

SUBJECT: Cash Basis Accounting vs. Accrual Basis Accounting

Hi Everyone,

When we compare and contrast cost basis accounting and accrual basis accounting, the biggest and most significant difference between the two is how they each recognize income and expenses. For instance, cash basis accounting reports income and expenses only when payment is received or made, whereas under accrual basis accounting, income and expenses are recognized when the given service or product is performed or received (Peek, 2019). Another difference between the two forms of accounting take place on the balance sheet. Under cash basis, the balance sheet does not report payables and receivables, but when using the accrual basis method, payables and receivables are reported (Gnanarajah, 2014).  Other differences that exist between the two methods are, cash basis accounting does not meet GAAP requirements, whereas accrual basis does and under cash basis, there is not a method for reporting partial payments or receipt of payment, but under accrual accounting, the opposite is true (Gnanarajah, 2014).  

When it comes to determining which of the two accounting methods provide more useful information on financial statements, in a 2014 study conducted by the Congressional Research Service, researchers determined the accrual basis of accounting is the winner (Gnanarajah, 2014). It was determined that though cash basis accounting is an easier method and may be a better fit for small companies that work in cash, overall, at the end of the day, it is accrual basis accounting that offers more information. Researcher Raj Gnanarajah said the following about why accrual basis is the better choice, “Provides more information regarding revenue and expenses of an entity; accounting for outstanding commitments and prepaid cash receipts, this method allows for more accurate measurement of net income or loss” (Gnanarajah, 2014).

Moving on, in order to support my conclusion of accrual basis being the accounting method that provides more useful information, below is an example that highlights the benefit of why accrual basis provides information that is more useful.

Let’s say I own a software company and I just provided my customer with the software I developed for them, and along with the product I provided the customer, I also included an invoice for my services of $10,000. Soon after I provide the customer with the software, I receive an invoice in the mail for $500 from the consulting firm I hired to help me with the development. A week later, I finally got around to paying a $100 bill that I received last month and I received a partial payment of $5,000 from my client. Under the cash basis method, for the given month that all of this activity occurred, my reported profit would be $4,900 ($5,000 in income - $100 bill I paid). In contrast, under the accrual basis method, my profit for the month would be reported as $9,500 ($10,000 in income - $500 consulting fee). In this example, the cash basis method is not accurately reflecting the company’s expenses and revenues for the given month, whereas under the accrual basis method, a clearer and more accurate picture of the financial activity and strength of my company is given (McCool, 2021).

 

Thanks,

Ryan

 

References

Gnanarajah, R. (2014, December 12). Cash Versus Accrual Basis of Accounting: An Introduction. FAS Project on Government Secrecy. https://sgp.fas.org/crs/misc/R43811.pdf

McCool, C. (2021, July 10). Cash basis accounting vs. accrual accounting. Bench. https://bench.co/blog/accounting/cash-vs-accrual-accounting/

Peek, S. (2019, June 6). Cash basis vs. accrual basis accounting. https://www.uschamber.com/co. https://www.uschamber.com/co/run/finance/cash-basis-vs-accrual-basis-accounting

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