Cash Versus accrual accounting

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The cash and accrual basis are the two methods of accounting. The difference between the two methods is how and when sales revenue and expenses are recognized. The cash basis of accounting recognizes sales revenue inflows when cash is received and operating expense outflows to generate sales revenue when cash is paid. Simply put, the cash basis recognizes sales revenue and operating expenses only when cash changes hands. The accrual basis of accounting recognizes inflows of sales revenue when earned and operating expense outflows to produce sales revenues when incurred; it does not matter when cash is received or paid. Many small operations use the cash basis of accounting when appropriate for their type of business; no requirement exists to prepare and re-port their financial position to external users.

The cash basis can be computed as follows:

Beginning cash + Cash sales revenue - Cash payments = Ending cash

There is no basic equation for the accrual basis.

To illustrate cash accounting, we will assume that a new restaurant purchased and sold inventory on a cash basis for two months of operation. A partial income statement prepared on a cash basis for the first two months of operation, assuming monthly sales revenue of $10,000 and total inventories of $8,000 for resale, would show the following:

                                                                       Month1               Month2


Cash sales revenue                                        $10,000                 $10,000 

Cash purchases                                               (8,000)                     -0-

Gross margin (before other expenses)            $2,000                  $10,000

This method gives a distorted view of the operations over the two months. The combined two-month gross profit would be $12,000; however, the accrual method will give a more accurate picture of the real situation, a gross margin (before other expenses) of $6,000 each month. In the following accrual example, cost of sales is estimated at 40 percent of sales revenue. Cost of sales refers to cost of goods sold.

                                                                       Month1               Month2


Cash sales revenue                                        $10,000                 $10,000 

Cost of sales                                                   (4,000)                  (4,000)

Gross margin (before other expenses)               $6,000                  $6,000

The examples given are not meant to suggest that the cash basis of accounting is never used. As indicated in the previous discussions, many small businesses find the cash basis appropriate. However, the cash basis is not considered adequate for medium and larger business organizations, which normally use the accrual basis of accounting. The accrual method is used throughout this text, except in cases where the cash concept supplements the decision-making process.

Without a basic knowledge of the system and the information provided, it will be difficult to produce or understand financial reports. The two major financial reports are the balance sheet and income statement.

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