Accrual vs. Cash
For the non-accountant, accrual accounting can seem as mysterious as Egyptian hieroglyphics. When working with basic small business financial statements, the accrual concept is easy to understand. However, in more complex business environments accrual accounting can become as exacting and tedious in its application as deciphering hieroglyphics. Fortunately, we are going to be discussing the
former, not the latter.
Let’s say you are in the business of selling T-shirts. Today you sold four T-shirts for $10 each. Two of the T-shirts sold were paid for with cash,i.e., $20. The other two were sold “on account”. In other words, the customers said they would pay you later. These two transactions have to be recorded differently on your books. Here is the journal entry for the first transaction.
|To record Cash sales|
Does this make sense? Check it against the Accounting Model. You increased Cash and you increased Sales, so are the amounts recorded properly in the debit and credit columns?
How about the “pay you later” transaction? We call that a “receivable” because money is owed to the business. Here is how it looks in journal entry form:
|To record Accrual sales|
Sales are said to be “accrued” when the payment for the goods or services is deferred to a later date. But, you might ask: Why are both the Cash and Accounts Receivable amounts listed in the debit column? It should be obvious that the General Ledger (GL) Sales account belongs in the Revenue section, but what section do the GL accounts, Cash and Accounts Receivable belong? They are Assets. Why? Because both of the items represent an economic resource that your company has possession and control over that will provide a future benefit. What happens when an Asset is increased? The Accounting Model tells us that
an increase of an Asset belongs on the “debit” side of the ledger.
Thirty days later your customers send you checks totaling $20 to pay for the T-Shirts. Here is how the transaction is booked:
|To record Cash “received on account” (ROA).|
What happened here? You received $20 Cash, put it in the bank, and you eliminated or canceled out the amount owed to you on the books.
Let’s look at Accounts Payable next. In this situation, we will assume that you bought some inventory (T-Shirts) for resale. You bought four T-Shirts altogether. You paid cash for two shirts and the other two you bought “on account”. Here is what it looks like in journal entry form:
|To record cash purchase of T-Shirts|
|To record payment “on account”.|
You decreased the Liability and decreased Cash. These are examples of the difference between an Accrual transaction and a Cash transaction.
Which one is better? It is not a question of better, it is a question of accuracy. If you include all accrual transactions on your books, the reader will have a more complete understanding of what is going on in your business than if only Cash transactions are recorded. Think about it with our examples. The Accrual
transactions would show more Assets, more Liabilities and more Revenue than the strictly Cash transactions. This reflects all the activity going on instead of just a portion. This is why the Financial Accounting Standards Board (FASB) requires that financial statements that are prepared using Generally Accepted Accounting Principles (GAAP) use the Accrual method of accounting.