Today, most small businesses start out using the cash basis of accounting because of its simplicity and
intuitive use. For small firms, with few transactions, this makes sense for the time being. However, once
a business starts to take off, it is important to start considering the switch to accrual accounting, as it
can give a better indication of business performance.
Before we get into the “why” of making the change, let’s review the definition, advantages, and
disadvantages of cash and accrual accounting.
Cash Accounting: records revenues when cash is received and expenses when cash is paid.
Revenues (=cash receipts)
- Expenses (=cash payments)
= Net Income (cash basis)
Advantages:
1. Simplicity
Disadvantages:
1. Provides an incorrect interpretation of future company performance
2. Not useful for external decision makers
Accrual Accounting: records revenues when earned and expenses when incurred, regardless of the
timing of cash receipts or payments.
Revenues (=when earned)
- Expenses (=when incurred)
= Net Income (accrual basis)
Advantages:
1. Provides a more accurate view of a company by smoothing out earnings overtime
2. Complies with GAAP
Disadvantages:
1. Complexity
2. Does not track cash flow
3. Taxes owed on money not yet received
When making the switch to accrual accounting, it is important to understand how accrual accounting
works. There are two basic principles that determine when revenues and expenses are recorded in
accrual accounting: revenue recognition and expense recognition.
The revenue recognition principle states that revenues are recognized when a) the earnings process is
nearly complete, b) an exchange has taken place, and c) collection is probable. For most transactions,
this occurs when a good or service is provided.
For example, an apparel company receives a $20 online order on July 20th , paid for with credit card.
Although the cash has not been received yet, an exchange has taken place. Revenue would be
recognized at this time and the item would be shipped to the customer.
The journal entry on July 20th would appear as:
Dr. Accounts Receivable $19
Dr. Credit Card Expense $1
Cr. Sales Revenue $20
Once the credit card payment goes through there would be another journal entry to recognize cash and reduce accounts receivable:
Dr. Cash $19
Cr. Accounts Receivable $19
The expense recognition principle, also known as the matching principle, requires that expenses be
recorded in the same time period when incurred in earning revenue.
To continue with the above example, let’s assume that the apparel item purchased is on hand prior to
the purchase being made.
A journal entry to purchase the inventory has previously been recorded as:
Dr. Inventory $5
Cr. Cash $5
Per the matching principle, the associated expenses would be recognized at the time the product was
sold on July 20th . The journal entry would be:
Dr. COGS $5
Cr. Inventory $5
As shown in the above accrual accounting example above, the revenue and associated expenses were
both recognized on July 20th – the date the transaction occurred.
Eventually, a successful business will be required to switch to accrual accounting for various reasons.
First, in order to comply with GAAP, the financial statements of a firm must be on an accrual basis.
Compliance with GAAP is important for companies that plan to receive a formal audit or to pursue an
initial public offering. If this is not incentive enough, the IRS also requires firms to switch from cash to
accrual once a business grows to a certain extent to comply with the tax code. Further, by tracking the
relationship between revenue and expenses through the matching principle, it gives you better insight
into profitability. You will have a more accurate picture of your company and you will be able to make
better decisions.
So why make the change before you must? The answer is simple – the smaller the firm, the easier the
transition.
