The two primary accounting methods used to produce financial records generate materially different reports. This is because the two methods have numerous differences, including the requirements to use them. Although both can be used and are accepted by external users, your company may be more suitable for the cash method or the accrual method.
Cash Method of Accounting
The cash method of accounting is a simplified system that records transactions based on when the cash element of the deal has been performed. In a sale, this is when cash is collected. For an expense, this is when the bill is paid. For example, you receive your telephone expense invoice on January 25. Payment is due February 15, and payment is made on this day. Because the cash transaction portion – your payment – occurred in February, the telephone expense is recorded in February.
Accrual Method of Accounting
The accrual method records transactions when the underlying transaction has occurred. It disregards when payment has occurred and includes the event in the financial statements based on revenue and expense recognition rules. In the example above, the telephone expense occurred in January because the telephone was used in January. Even if the invoice was paid three months late, the charges related to usage in a specific month so that is where an accrual method entry would place the transaction.
Accruals and Deferrals
The main difference between these two methods are accruals and deferrals. These two types of adjusting entries occur in an accrual system and do not occur in a cash accounting system. An accrual reports a transaction before cash has been collected or paid. The telephone expense example above is an accrual entry. This is because the expense occurred and no payment was made; the adjusting entry places a liability on the balance sheet to demonstrate the bill is owed.
Alternatively, a deferral adjustment occurs after the cash portion of the transaction has occurred but the underlying benefit is not yet completed. For example, imagine purchasing $100 of printer paper classified as an office expense. In a cash accounting system, the $100 expense is recognized when you buy the paper. In an accrual method system, the $100 is recorded as an asset on the balance sheet (called supplies). As the supplies are used, an expense is recorded. Therefore, if $10 of printer paper is used each month, a $10 supply expense is adjusted.
Both methods have restrictions. Larger public companies are required to use the accrual method of accounting. In addition, the accrual method is more difficult, timely and expensive to incorporate into your records. While the cash method is easier, it potentially leads to misleading financial statements. An example occurs with the supply expense above; $100 of printer paper was purchased but not used, so the information is slightly incorrect. In addition, the cash method fails to record payables or receivables, it becomes more difficult to forecast future cash flows from operations.