Cash basis vs accrual accounting

Cash basis accounting vs accrual accounting

• What the instructor sets up: cash basis vs accrual accounting.

• Cash basis accounting basics:

  • Revenue is counted when cash is received; there is no distinction between revenue and cash inflow.
  • Expenses are counted when cash is paid; there is no distinction between expenses and cash outflow.
  • This approach is commonly used for personal taxes.

• Accrual accounting basics:

  • Accrual accounting is what GAAP requires for financial reporting.
  • Adjusting entries in this course are built around accrual accounting.
  • We have already seen early accrual concepts in action via accounts payable and accounts receivable (AR/AP).

• Practical setup and preview:

  • The instructor references a Stone 3-1 scenario in the textbook to illustrate the distinction between cash basis and accrual basis (you are encouraged to read the scenario in the book).
  • The scenario involves a company contracting with a city government and performing work in November.
  • The company bills and incurs expenses in November, but cash flows occur later.
  • The point is to compare what happens under cash basis versus accrual basis accounting.

The Stone 3-1 scenario (November–December–January) and the contrast

• Scenario details (as described):

  • Work performed in November; the company presents the bill in November; all related expenses are incurred in November.
  • Under cash basis:
  • November: Revenue = 0, Expenses = 0 (no cash in or out yet).
  • December: No revenue, Expenses = \$60{,}000 (cash outflow to pay the expenses).
  • January: Revenue = \$100{,}000 (collected from the billed work); Expenses = 0 (expenses already paid in December).
  • Consequence: The income statements for November, December, and January under cash basis do not reflect the economic activity accurately.

• Accrual accounting treatment in the same scenario:

  • Revenue recognized when earned: Revenue = \$100{,}000.
  • Expenses recognized when incurred: Expenses = \$60{,}000.
  • Net income under accrual: $ext{Income} = 100{,}000 - 60{,}000 = 40{,}000.$
  • This aligns with economic reality and GAAP expectations, unlike the cash basis view.

• Summary takeaway from the example:

  • Accrual accounting provides a truer picture of performance across the period.
  • Cash basis can misstate performance and timing of revenue and expenses.
  • The difference between the two methods is foundational for how financial statements are understood and analyzed.

• Instructor’s note on scope:

  • This is a simplified illustration; the course emphasizes accrual and adjusting entries and indicates we will return to this topic in future sessions.
  • The goal is to understand that GAAP requires accrual accounting and that the upcoming adjusting entries will further build on this foundation.

Accrual accounting in practice and adjusting entries (conceptual)

• Core idea: In accrual accounting, you recognize revenues when earned and expenses when incurred.

• How this connects to AR and AP:

  • Accounts Receivable (AR) and Accounts Payable (AP) are early examples of accrual concepts.
  • AR arises when revenue is earned but cash has not yet been collected.
  • AP arises when an expense is incurred but cash has not yet been paid.

• The example of a typical expense: a phone or utility bill

  • When the company receives the bill (the obligation is measured accurately), you record the expense now and create a payable.
  • Journal entries exemplified:
  • Upon incurring the expense (recognize the liability):
    • Dr. Expense
    • Cr. Accounts Payable
  • When paying the bill later:
    • Dr. Accounts Payable
    • Cr. Cash

• Cash basis alternative (for contrast):

  • Under cash basis, the expense would be recognized only when cash is actually paid, not when the obligation is incurred.
  • This is considered improper from a GAAP perspective for accrual-based reporting.

• Connection to broader course goals:

  • The upcoming module will introduce adjusting entries, which are all about accrual accounting.
  • The adjusting entries framework will lay more groundwork for understanding how accruals and deferrals (as appropriate) affect financial statements in later chapters.

Practical implications and real-world relevance

• Why accrual accounting matters:

  • Provides a timing match between revenues earned and expenses incurred.
  • Produces financial statements that reflect economic activity more accurately, supporting better decision-making and compliance with GAAP.

• Real-world relevance:

  • Companies rely on accrual accounting to present a faithful representation of performance over reporting periods.
  • Misstating earnings and liabilities with cash basis can mislead investors, lenders, and managers.

• Ethical and practical implications:

  • Using accrual accounting aligns with professional standards (GAAP) and reduces incentives to manipulate earnings through timing differences.

• What to expect next in the course:

  • Deeper exploration of adjusting entries and more detailed accrual mechanics.
  • Further connections to accounting cycles, financial statements, and real-world applications.

• Pause and reference:

  • Remember to consult Stone 3-1 in your textbook for the concrete scenario used to illustrate these concepts.

• Quick recap:

  • Cash basis: revenue when cash is received; expenses when cash is paid – simple but often misaligned with economic reality.
  • Accrual basis (GAAP): revenue when earned; expenses when incurred – supports accurate, GAAP-compliant financial reporting.
  • The November–December–January example demonstrates how accrual yields a favorable alignment with actual economic activity, while cash basis can distort timing and profitability.

• Next steps mentioned by the instructor:

  • We will cover adjusting entries in the next presentation and build a more robust foundation for accrual accounting.