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Cash vs. accrual accounting
Published on February 28, 2017 9 min
Other Talks in the Series: Analysing Financial Statements
Hi, and welcome to part three of Cash vs. Accrual Accounting in this HSTalks series on Analyzing Financial Statements. My name is Dr. David Bond. In this part, we'll explore the differences between cash and accrual accounting as well as the four main situations which require adjusting entry.
A quick recap from part two is that one of the main purposes of an accounting information system is to generate a set of financial statements based on the business activities of the entity. Of particular interest to users is the net profit of the entity, which is calculated by taking revenues and subtracting expenses.
There are two different ways in which an entity can record revenues and expenses. The first is the cash basis of accounting, the second is the accrual basis of accounting. The main difference between the two is the timing of when revenues and expenses are recorded. Under the cash basis of accounting, revenues are recorded when cash is received whilst expenses are recorded when cash is paid. Under the accrual basis of accounting, revenues are recorded when they are earned whilst expenses are recorded when they are incurred.
For example, when you buy a ticket for a flight on a commercial airline, you pay for this in advance, in some cases, many months in advance. Let's assume that on the 15th of January, I pay $100 to purchase a ticket to fly from Sydney to Melbourne one way. The date of the flight is the 12th of August. Under the cash basis of accounting, the airline would record $100 of revenue on the 15th of January as that is when they received the cash from me. Under the accrual basis of accounting however, the airline would record cash being received on the 15th of January but no revenue. They would only record the revenue for the flight on the 12th of August. We'll look at the entries required in more detail in a few moments. The cash basis of accounting is generally used by small to medium enterprises as it is less costly to prepare financial statements this why. For larger entities, i.e., those using IFRS or US GAAP, the accrual basis of accounting is required.