Cash basis - REVENUES are recorded when RECEIVED and EXPENSES when PAID.
Accrual basis – REVENUES are recorded when EARNED and EXPENSES are recorded when INCURRED.
Let me illustrate this by example.
You own and operate a store called Cupcake Designs where you make and sell custom cupcakes. You rent the store where you operate from. How do you record the following transactions?
1) REVENUE – Your customer purchased and received $500 worth of cupcakes and you sent your customer an invoice to be paid within 30 days.
2) EXPENSE - You received the store rental invoice for the month of $1,000 and since you are short of cash, you plan to pay this sometime next month.
With Cash Basis Accounting –your revenues for the day will be ZERO, since your customer hasn’t paid you yet. Your Rent Expense will also be ZERO since you haven’t paid the rent for the store just yet.
With Accrual Basis Accounting – your revenues for the day will be $500. Why? You EARNED this amount the moment you completed the transaction which is when your customer received the cupcakes purchased. Your Rent expense for the month is $1,000. You INCURRED this expense for the month as this is where you operate from.
Notice with the example above, using cash basis accounting – it will appear like you have no revenues or expenses for the period. But think about it, is that true? NO. Do your revenues properly MATCH with the expenses for the same period?
The matching principle addresses properly matching the revenues and expenses of the company in the period that the events took place. With accrual basis accounting – the revenues EARNED are recorded and MATCHED with the expenses INCURRED for the period.
Accrual Basis accounting follows the standards of Generally Accepted Accounting Principles (GAAP). GAAP are standards used to provide uniformity and consistency of how financial statements are prepared and presented. Cash basis accounting does not conform to GAAP standards. For ease of keeping track of transactions, some small business start-up set up their books using the cash basis, as the business improves, they then switch to accrual.
Given today’s advances in technology, maintaining an organization’s books using the accrual basis is fairly easy. Many accounting software applications are user-friendly and affordable to use like QuickBooks, FreshBooks & Xero, to name a few. They also come in either desktop or cloud platforms to make information readily available.
How do you easily SPOT if the financial statements are prepared using CASH versus ACCRUAL basis? Read the balance sheet and look for these accounts: ACCOUNTS RECEIVABLE and ACCOUNTS PAYABLE. Why?
Let’s go back to my example earlier. If you were using accrual basis accounting, how will you record the transactions above where revenues are earned and expenses are incurred?
Dr. Accounts Receivable $500 and Cr. Sales $500
Dr. Rent Expense $1,000 and Cr. Accounts Payable $1,000
Refer to my accounting tutorials for more details on how to set up your accounting books and records.