Bases of Accounting

Michael Sack Elmaleh, C.P.A., C.V.A.

accrual mistress

Is it possible to accurately assess how a business performed if only cash transactions are recorded in the general ledger? The answer, to a certain extent, depends upon the nature of the business, but generally recording only cash exchanges will lead to problems in measuring economic performance. An example will illustrate these difficulties.

Example. Suppose you are the bookkeeper for Joint Ventures, a delivery business. As bookkeeper you record all transactions based upon entries you find in the company’s checkbook register for the month. Let’s say the December checkbook has only two entries: 

check register

Based on this register you record the two transactions in the general journal and then post to the appropriate accounts. The owner, Jimmy Morrisin, wants you to prepare an income statement for the month of December. Since there is only one income item and one expense item, your income statement will look like: 

cash basincome statement

Jimmy looks at this financial statement and says “bummer.” Then he gazes intently at the statement and says “whoa man, you must be smoking too much of the product I deliver, because I had a way better month than your statement indicates. I mean, I did a $50,000 delivery for the Columbian Growers Co-op. The $5,000 deposit in December was just the up front fee. I made the delivery in late December, and they paid me the $45,000 balance at the beginning of January. But I earned the whole fee in December, because that’s when I made the delivery.”

“For another thing, that $9,000 payment to Hurts is for three months plane rental. Those mothers make me pay three months in advance. The way I figure, only $3,000 should count against December, and the rest should go against January and February.” 

“It seems to me, I really earned $47 K rather than lost $4 K.” 

You say sheepishly,  “Look, I only went by the check book, and it says you took in only $5,000 in revenue and spent $9,000. Looking at cash, you were down $4,000 for the month.  Besides, it will all even out over a long enough period of time.” 

“Well, yeah,” answers Jim. “I can see your point, but what if I want a more accurate picture of what actually happened in December? I’m interested in the long run. But I also want to know what happened in the most recent month because I want to respond quickly to any good or bad trends that might be showing up in the numbers. No offense, but that statement you gave me does not reflect what really happened in December.”

Economic Reality and the Matching Concept

What does Jim mean by asking you for a more accurate picture? He intuitively knows there is a natural and logical causal relationship between revenue and the expenses it takes to generate that revenue. The attempt to capture this causal relationship between revenue and expense is called the matching concept. By this matching concept, Jim realized that he really earned $50,000 in fees in December and incurred only $3,000 in expenses. He knew that recording only the cash transactions distorted this economic reality.

Accrual Accounting

Because of the potential economic distortions caused by recording only cash transactions, GAAP requires revenue and expenses to be recorded on an accrual basis. This means that a business records revenue when the earning process is complete, not necessarily when cash is received. For example, a tavern that allows customers to run a tab records revenue when the customer receives the drink, not when the tab is paid. 

Similarly, an accrual basis of accounting requires expenses to be recorded when the business receives the goods and services, not necessarily when the business actually pays for them.  If a bar receives a supply of napkins but does not pay for them for thirty days, the expense is recognized when the napkins are delivered and used, not when the bill is paid.

Advantages and Disadvantages of Cash and Accrual Systems  

A business that records revenue only when cash is received, and expenses only when they are paid is said to be on the cash basis of accounting. An obvious advantage of the cash basis over the accrual basis is that it is much simpler. An accrual system requires more accounts, including accounts receivable, accounts payable, inventory, prepaid expenses, and deferred revenue. Each of these accrual accounts requires making estimates and sometimes complex computations. As in machinery, the more moving parts the more potential problems. 

The cash basis accounting approach requires no complemeasurements or estimates. An expense is recognized only when a vendor is paid for a product or service. Revenue is recorded only when a customer or client pays for products sold or services rendered.

The disadvantage of the cash basis system is that for any particular short period of time operating results can be greatly distorted from economic reality. The distortions usually result from transactions occurring near the end of accounting periods.

Does Cash Basis Accounting Always Provide Different Operating Results ?

The answer is no. If most of a firm’s sales are cash sales and most expenses are paid immediately, there is little difference between the measured operating results using a cash basis versus an accrual basis of accounting. However, if a business extends credit to customers, has credit extended to it, or carries significant amounts of inventory, the differences in reported operating results using the two approaches can be significant.  

For many businesses, cash collections may lag behind earnings by two to three months. Payments on expenses may also lag as much as sixty days from the receipt of goods and services. In these cases, cash basis earnings may greatly differ from accrual basis earnings.

Over the entire life cycle of a business, cumulative operating results are the same under both bases of accounting. In fact, year to year the differences may not be that great if the levels of revenue and expense remain stable and the collection and payment cycles do not fluctuate. The greatest variation between accrual and cash basis accounting tends to occur in the initial and ending periods of a firm’s life cycle, or during periods of significant growth or decline. Short term monthly and quarterly reporting also can be greatly different.  As our friend Jim indicated, accurate short term reporting is very important in managing a business.

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Financial Accounting by Mike Elmaleh

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