Accrual Accounting and
Cash Accounting

Under the Accrual Accounting Method, revenues are recognized and reported when they are earned, whether or not cash is received. Expenses are recognized when they occur, whether or not cash is paid. Under the Cash Accounting Method, revenues are reported when cash is received, and expenses are reported when cash is paid.

For example, assume Sunny Sunglasses Shop purchases inventory for $1950 in Period One on credit. Sunny sells the same sunglasses for $6500 in Period One on credit.

In period Two Sunny receives payment for the sale in cash for $6500, and in turn pays for the inventory with cash in Period Three ($1950). The Cash and Accrual Method would account for net income during Periods One, Two, and Three as follows:

Cash-Basis Accounting	Period 1	Period 2	Period 3	Total
Cash Receipts	$0	$6,500	$0	$6,500
Cash Disbursements	$0	$0	$(1,950)	$(1,950)
Net Income	$0	$6,500	$(1,950)	$4,550

Accrual Method	Period 1	Period 2	Period 3	Total
Cash Receipts	$6,500	$0	$0	$6,500
Cash Disbursements	$(1,950)	$0	$0	$(1,950)
Net Income	$4,550	$0	$0	$4,550

Notice that even though both methods result in the same total, the difference between the two methods lies in the timing of net income.

The Cash-Basis Accounting resulted in zero income in Period One since no cash was received or spent. The cash method only recognized cash when received in Period Two, and expenses when paid with cash in Period Three.

Under Accrual Accounting the company incurred an expense in purchasing the inventory in Period One, even though no cash was spent. Revenue was recognized when earned, even though no cash was received at the time of the transaction.

Many small businesses use the Cash Basis of accounting, as well as individuals for both personal finances and filing income taxes.

However, Generally Accepted Accounting Principles (GAAP) requires that businesses use the Accrual Method of accounting since this method more accurately represents the financial state of a business at a given point in time.

The Cash Flow Statement reconciles net income under the Accrual Method, to actual cash on hand. This is important since a company may have substantial revenue, but be short on cash for one reason or another (e.g. customers’ nonpayment or bad debt) under the Accrual Method.

The examples presented on this website use the Accrual Method for the production of the financial statements.


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