Cash vs. Accrual Accounting
There are two common bases used to prepare the statements; cash basis and accrual basis. Accrual basis is the most widely used accounting method, as most companies conduct business using credit. According to Kimmel, Weygandt, and Kieso, (2011), the accrual basis of accounting recognizes the impact of transactions on the financial statements in the periods when revenues and expenses occur, instead of when the company receives or pays cash. This means that with the accrual basis, the company’s sales and purchases are recorded when the deal happens, not necessarily when money actually changes hands. For example, with the accrual method, inventory becomes an asset until the period when the actual inventory expense occurs.
The cash basis method of accounting is only concerned with when money actually changes hands. This method ignores any transactions on credit and only looks at when the cash obligations are fulfilled. Suppose Proctor and Gamble (P & G) entered into a deal with a customer in May for a large order to be delivered and paid for in August, additionally, assume this is the only customer P & G has at the time. P & G would have to purchase the raw materials to complete that order, and if they paid in cash, the expense would come in May. The company would not have any revenue for the months of May through July, but would have expenses. The company would appear to be operating at a complete loss. When August comes, however, the company would record the cash payment from the customer and its financials would show no expenses, but income from the sale. The cash method can lead to inaccurate analysis of a company, as the efforts and benefits are not connected in the same way as they would be in the accrual basis accounting method. But either method is useful depending on the size of the company. Large companies with complex transactions really would need to use the accrual basis of accounting in order to maintain accuracy.
Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2011). Financial accounting: Tools for business decision making (6th ed.). Hoboken, NJ: John Wiley & Sons.