BUS 241 Video 7 Accrual vs. Cash Basis of Accounting

Cash Basis of Accounting

  • Definition: Recognizes revenues and expenses based on the actual cash flows.

  • Revenue Recognition: Revenue is recognized when cash is received.

  • Expense Recognition: Expenses are recognized when cash is paid out.

  • Usage: Often used by small businesses; less common for larger companies.

Accrual Basis of Accounting

  • Definition: Recognizes revenues and expenses when they are earned or incurred, regardless of cash flows.

  • Revenue Recognition: Revenue is recognized when it is earned, not when cash is received.

  • Expense Recognition: Expenses are recognized when they are incurred, not when paid.

  • Usage: Predominantly used by most businesses (99% of the time).

  • Purpose: To match revenues and expenses in the correct accounting period for accurate financial reporting.

Example of Insurance Policy

  • Scenario: An 18-month insurance policy purchased for $1,800.

Cash Basis Treatment

  • Date of Purchase: December 1

  • Expense Recognition: Full $1,800 recognized as an expense in Year 1.

Accrual Basis Treatment

  • Monthly Expense Calculation: $1,800 divided by 18 months = $100 per month.

  • Year 1:

    • Only recognized for December (1 month): $100

  • Year 2:

    • Full 12 months: $1,200 (12 months x $100)

  • Year 3:

    • Remaining 5 months: $500 (5 months x $100)

Summary of Differences

  • Cash Basis: Recognizes the entire $1,800 expense in Year 1.

  • Accrual Basis: Spreads the expense across 18 months, recognizing only $100 in Year 1, $1,200 in Year 2, and $500 in Year 3.

  • Revenue Similarity: Under accrual accounting, revenues are equally recognized when earned, aligning with expenses for better time period matching.