Accrual basis and cash basis are the most fundamental concepts of accounting. Students, who major in business administration or accounting, often learn these definitions on the first days in their accounting classes. When I first learned about these two methods in my accounting classes in college, I thought that a business could only follow either a cash structure or an accrual structure. It cannot pursue the two methods at the same time. However, after working for different companies that implement both, I got that a company that is under cash accounting can still use an accrual method. In this post, I will go over and discuss the accrual basis in those cash-based companies, as well as the differences between cash-based and accrual-based companies regarding accrual procedures.
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Accounts Receivable and Accounts Payable
For businesses that follow a cash-based model, they still need to use some accrual ideas, such as accounts receivable and accounts payable. It is a common knowledge that accounts receivable allows a company to recognize revenues even if it has not yet received any cash, and accounts payable enables the company to recognize expenses even if it has not yet paid out any money. This approach of accrual basis is completely opposite from the cash-based approach, which states that costs and revenues can only be recognized when there is cash involved.
The reason why cash-based businesses must use accounts receivable and accounts payable is because of accounting software programs they use. In these programs, accounts receivable and accounts payable are the two default modules, along with the general ledger module. Sales invoices are raised in the accounts receivable module, and vendor invoices are created in the accounts payable module. I cannot imagine an accounting software solution that does not have these modules for recording sales and payment activities. I guess due to the dominance of accrual-based businesses, most of the accounting programs in the market are designed for an accrual basis.
For example, when a bookkeeper creates a sales invoice in the accounting system of his or her company, revenue is immediately recognized and accounts receivable balance increases. The accounting system cannot tell and does not care whether the company follows a cash basis or an accrual basis. The accountant must adjust the general ledger and financial statements to reflect the cash nature of his or her business. In this particular example, the bookkeeper can book a monthly temporary journal entry to remove the accounts receivable balance from the total revenue.
Similarly, the accountant can book another monthly temporary entry to deduct the payable balance from the company’s total cost. Alternatively, the company can issue payments to all vendors as soon as invoices are entered into the accounting system. By doing this way, the accounts payable balance is always zero. Thus, it will not have any impact on the income statement.
Differences in Accrual Journal Entries between Accrual Basis and Cash Basis
For cash-based organizations, they sill prepare accrual for revenues and expenses to some extent, especially when they need to submit their financial reports to external stakeholders. However, the frequency of accruals in cash-based entities is much less than that of accrual-based firms. For instance, I used to work for a cash-based company in Irvine. This company did not accrue for any revenues or expenses until the year-end closing. In contrast, for other accrual-based companies that I used to work for, they book accrual journal entries monthly during month-end closings. The second difference is the method of accrual. In cash-based companies, their accruals are built on the numbers of months. Meanwhile, in companies that are on an accrual basis, their accruals are based on the service periods.
To illustrate this point, let’s go back to my former cash-based employer. I still remember every time I submitted my year-end accrual entries to my supervisor at that company; he always checked my work by looking at the trend report and counting the number of months. If there were any expenses incurred in less than twelve months, my supervisor would ask me to accrue for the average amount multiplied by the number of missing months. For example, if electricity expenses were paid only ten times in that year, my boss would ask me to accrue for two more months. The bottom line is that I needed to ensure that all revenues and expenses were twelve months’ worth. For the accruals in my other companies that follow accrual basis, the service periods of a cost or revenue is more critical. For example, if I am doing month-end accruals for July 2020, any invoices that have the service period pertaining to July 2020 will need to be accrued for.
The third and final difference is that cash-based companies accrue for only certain expenses and revenues, especially if they are recurring (e.g., utilities, maintenance costs). Accrual-based companies, on the other hand, accrue for almost all of the profit and loss (P&L) accounts. As a result, the accrual tasks in accrual-based companies are much heavier than the accruals in cash-based companies.
What I have mentioned in this post is the main differences between accrual-based companies and cash-based companies. As can be seen, contrary to the public belief, companies that follow a cash basis still carries out a few accrual projects. Nonetheless, the frequency, the number of accounts involved, and the method of accruing is much less intense than those in accrual-based firms.