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Cash vs. accrual accounting

Two principal accounting methods exist to record business transactions: cash accounting and accrual accounting. Accrual accounting is the standard system, but it is useful to be aware of both methods.

Cash accounting

In short, this is a straightforward system where transactions are documented as they occur. One records revenue as it comes in and expenses as they are paid. This type of accounting requires little subjective judgment as the timing (and the obviousness) of the transaction dictates when the journal entry is made. The drawback with this type of accounting is that it does not represent events which are not a business transaction or exchange, such assets or liabilities building up or expiring over time (examples being interest earned at the bank or the depreciation of computer hardware). This method is primarily useful for uncomplicated accounting situations, such as keeping the financial records of an individual.

Accrual accounting

Using this system, one records (or“recognizes”) revenue as it is earned as opposed to when it is received. Thus revenues appear as journal entries once the product or service is delivered to the customer (i.e., when assets are created or liabilities decreased), regardless of when the related payment comes in. Similarly, expenses are recognized as they arise (i.e., when liabilities are increased or assets decreased) and not when they are paid out.

Accrual accounting involves two fundamental principles—to recognize the business transaction, and to periodically adjust the financial statements so that the net income for a given period will reflect a match between that period’s associated revenues and its expenses. In applying these principles, the periodic adjustments allow for the inclusion into the accounts of economic events that did not involve a business exchange or transaction, such as interest gained at the bank or depreciation of computer equipment.

References

Markle, K. (2004, August).Introduction to Accounting.Presentation delivered at Schulich School of Business, York University, Toronto, Canada.
Pratt, Jamie. (2003).Financial Accounting in an Economic Context.New York: John Wiley& Sons.

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