Accrual Accounting versus Cash Accounting

Accrual or Cash…that is the question. It is an important question, and not only for beginners studying accounting, but also for entrepreneurs planning to start a business.

It is a fundamental question that will impact all future decisions. It is similar to choosing the foundation for a house. If you choose the wrong foundation the house may cave!

 

 

Before we get to the differences between the two systems, its vital to understand what they have in common. The most important thing to know is that both systems are: methods to consistently keep track of income and expenses

 

Why is this important? Because money is important! And knowing how/when to record (count) it is crucial to establishing good business habits!

 

On to the differences...

 

Here is an example that will get us thinking about how and when to count money:

Let’s say you’re in the business of mowing lawns. You have a neighbor, who, for sake of simplicity, we will call Larry. Larry is lazy, and his lawn looks as if it has not been cut in decades. One day while eating breakfast, Larry decides he will fish through the heap of mail that has been accruing on his counter for months. Suddenly he stumbles across your flyer, “Does your lawn look like a jungle?” Call the jungle man now!” Next thing you know, you and Larry agree that you will cut his lawn for $100.00. The following day you cut his lawn, and he agrees to pay you in a week. So the BIG QUESTION becomes…do you record (count) the $100 now? Or when you actually get paid by Larry? Many of our brains are accustomed to recording the money when its actually in our hands. But answering this question depends on whether or not you use the accrual or cash system.

The main difference between the two is that they record income and expenses at different times. Below are the key characteristics of each:

 

Cash System

  • Income is recorded when the cash is received
  • Expenses are recorded when the cash is paid

 

Accrual System

  • Income is recorded when service is performed
  • Expenses are recorded when the service is completed

If you were using the cash system, you couldn’t record the income until Larry actually paid you. If, on the other hand, you were using the accrual, you could record the income as soon as you chopped the last blade of grass.

Both systems have advantages and disadvantages. In regards to the Larry example:

 

 

 

 

Cash System

Advantages are that the books reflect an accurate depiction of your current situation. Disadvantage is that Larry may be late in paying you, and you can’t count it as revenue until he pays you. This means that you may not be able to take out a loan on a new lawn mower because the bank doesn’t see that you have any way to repay them

 

Accrual System

Advantages are that is depicts a more accurate picture based on the services actually performed. If larry owes you money, you should be able to record that money as if you have it. This means that you can secure that loan from the bank. Disadvantages are that if people don’t pay, your books can be misleading. In that case, you may take out a loan that you can’t pay back.

There are rules that require a business owner to use one or the other. But from the student’s perspective, the important thing to remember is that one records transactions when the cash exchanges hands, and the other records when the service is rendered.

 

 

 

 

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