After learnt about the impact of Account Receivable, Prepaid Expenses, Accounts Payable, Deferred Revenue and Inventory to the financial statements, you should see the timing differences in recognising revenue and expenses.
If we put the situation in accounting terms, revenues are recognized and recorded when an economic exchange occurs, while expenses are recognized when the associated revenues are recognized, not necessarily when cash is exchanged.
The way we treat these situations is called Accrual Accounting. Let us break this down to layman terms:
- Suppose McDonald’s purchases raw materials (buns, beef patties, paper cups, salad ingredients and packaging, etc.) weeks/months before any revenue is recognized (when we buy McD meals).
- If McD recognized the expenses of purchasing raw materials then instead of matching revenues with expenses,McD would have reported the material costs back when they were acquired on their financial statements. We would see inflated costs and low revenue in the financial statements.
- This would not be an accurate reflection of the company’s profitability because we know McD purchased these raw materials to fill our orders that will lead to future revenue.
- By matching costs with revenues, the accrual concept attempts to represent a company’s operating results more accurately.
The following is the key differences between Cash Accounting and Accrual Accounting.
|Cash Accounting||Accrual Accounting|
|Record income when you receive it||Record income when you earn it.|
|Record an expense when you pay it||Record an expense when you incur it.|
We can always make more complicated comparison as below. 😁😁🔥🔥
|Cash Accounting||Accrual Accounting|
|Purpose||Track movement of cash||Allocate revenues and expenses to create a more accurate depiction of operations|
|Revenue Recognition||Cash is received||Economic exchange is almost or fully complete|
|Expense Recognition||Cash is paid out – could be in a different period from revenue recognition||Expenses associated with a product must be recorded during the same period as revenue generated from it (Matching Principle)|
|Judgment||Movement of cash is objective||Allocation of revenues and expenses to different periods is subjective|
The fact is that both cash accounting and accrual accounting have their advantages. Regardless of which method a company uses, it will probably secretly use a bit of both.
One of the biggest advantages of cash-basis accounting is that it gives businesses an accurate picture of how much money is changing hands. If they are not taking in cash as fast as they are spending it, they are going to be in trouble. If they have to pay vendors and suppliers immediately, but wait for their own customers to pay in 30 days, they’ll be chasing bills forever and hoping the lights stay on.
That’s why accrual accounting companies need to prepare a cash flow statement. This allows them to keep track of cash while accounting for accrued revenue and expenses. By tracking cash flow, companies will forecast any shortfalls where they might run out of money before the next payments arrive.
Companies that use the cash method sometimes rely on accrual accounting principles, even though they do not report them on their books. Remember accounts receivable and accounts payable? When they have a customer who owes them money, they count the days until they can expect the check, even if their books do not show a receivable account anywhere. The same is true when a rent payment is due.
The biggest shortcoming of cash-basis accounting is the difficulty of measuring business performance. To really get a good overview of a company’s performance, we need to set and track KPIs. We need to be able to track them and see how they change to really understand the health of the business. Unfortunately, this is next to impossible on a cash basis.
To track profitability, we need to know not only how much money is coming in and going out, but also how those amounts are connected. We need to know how much is associated with each period and the transactions in that period. This is the matching principle we talked about earlier. You need to match your expenses with the revenues that caused them. Accrual accounting makes this possible.