The Accrual Basis: How It Differs from Cash Basis
Accrual basis vs. cash basis accounting methods are quite confusing, particularly for those who have just started a new business. The accrual method can be considered as a less likely choice if a non-accountant will perform the accounting process. The accrual method is quite complicated because it involves correlated actions of recognizing, amortizing or deferring expenses or income without considering if an actual exchange of cash had taken place.
As opposed to cash basis, wherein the income and expense transactions are included for as long as they cause a decrease or increase in the cash balance. Hence, cash basis is often the popular choice because it is easy and simple. But as far as determining your actual gains or losses are concerned, it is effective only if your business runs on a purely cash basis and does not maintain any merchandise inventory.
As trade and commerce advanced with technological developments, so did the accounting process. The accrual method is a system that was established in order to recognize the expenses incurred in relation to the income it generated. Income on the other hand, was included if it was actually earned. Businesses who receive advances or prepayments will consider payments received in advance as unearned income booked as liabilities. They will be actually recognized as income until such time that the services or products have been served.
Conversely, businesses that make prepayments for services or products that are yet to be delivered will book their advance payments in an other asset account. They will be recognized as expenses on the actual dates that they inure to or upon actual application of their prepayment. An example of this is an advanced rent deposit paid as a prerequisite for rental agreements. This is illustrated in the comparative examples on how net income is computed using accrual basis vs. cash basis shown on the next page.
Any mismatch between the expenses deducted against the reported income may result to an understatement or overstatement of net income. The Internal Revenue Service (IRS) often frowns upon an understatement of net income because it will appear that it was deliberately done to reduce the tax obligations for the year. On the other hand, investors will not consider the business as a worthy investment prospect since a losing-entity is hardly a good investment choice.
If your income is overstated as a result of using the inappropriate accounting method to match income and expenses, it will also put you at the losing end. Your tax obligations will be bloated and you might be paying more than what is due. On the part of the investors, once they get to see the true picture of your business and perceive that the income reported is hardly a reflection of your company’s performance.
In a separate article entitled Top Ten Accounting Scandals that Changed the Business World, readers will learn how accounting irregularities led to the downfall of top companies who were charged with fraud, for presenting investors with misleading financial reports about their business conditions.
To illustrate the effects of accrual basis vs. cash basis pertaining to how expenses that were paid in advance or income that was received in advance are treated, please proceed to the second page to view comparative examples.