Cash or Accrual? What’s the Difference?

Nov 09, 2020 by Roger Scherping

I often talk with my clients about their financial statements, and I’ve learned that most people think about profit and loss in terms of cash. They say things like, “We had a great month because we got paid $50,000 from our best client,” or, “This was a bad month because we had to pay lots of bills.” In other words, they think that their income statement should reflect when they get paid and when they pay their bills.

That’s what we call the cash basis: Nothing happens until cash changes hands. That might be fine when it comes to filing your tax return, but it can be downright misleading when it comes to understanding the economic activity of your business!

Excavating Business

I have a client that is in the excavating business. Being that we are in Minnesota, theirs is a highly seasonal business. When I first started working with them, I reviewed their income statement with the leadership team. It was obvious to me that they were doing their books on the cash basis, and I showed the team why that wasn’t a good idea.

I asked them, “Your income statement says that your busiest months last year (the ones with the highest revenue) were October, November and December.” They all laughed and quickly said that that was not right. Their busiest months are, of course, the summer months. So I asked them why their income statement shows the fourth quarter as their busiest time. They were all puzzled and had no idea.

So I asked them if it would make more sense for their income statement to show that their busiest months were the months when they were actually the busiest. They all agreed and were intrigued to learn more.

So I told them that we can change their accounting system so that when you get paid does not matter! That’s right. We don’t care about when you get paid. Instead, we care about when the work was performed!

Economic Activity

I told them if we do the work in June, then we want June’s income statement to reflect that revenue. Recording the revenue in August when you get paid doesn’t accurately reflect what is happening in the business. You did the work in June, so we should record the revenue in June because that reflects the true economic activity of the business.

And that’s what it’s really all about. We want an income statement that accurately reflects the economic activity of our business – that is, it should reflect when the work was performed. The income statement should accurately reflect when we were busy. That’s the only way our income statement can be helpful to us in running our business.

Think about it. You’re looking at your June income statement, and it shows that you had no revenue. But you know that the dozers and dump trucks were going like crazy, and your employees were all working overtime. Why should your income statement show that you weren’t generating any revenue in June?

So we changed their accounting system to the accrual basis. On the accrual basis, cash transactions don’t matter. When we get paid simply doesn’t matter.
 
What matters is, what economic activity happened this month? If we did the work in June, and we sent the invoice to our customer in June, then June is when we should recognize the revenue for the work. We may get paid for that work in July or August, but that doesn’t matter. June is when the work was performed!

Same Thing for Expenses

The same thing is true for expenses. We could collect all of our unpaid bills in a file, and when it comes time to pay one we could enter the bill into the computer and pay it. But if we did that, then the month when we paid the bill would show that expense.

On the accrual basis, we want to record that bill in the month in which we incurred it. This means recording the bill in the month when we received the materials from our vendor or had the vendor do the work for us. In this way the bill will hit expense in the correct month, and our expenses will reflect the true economic activity of our business. When we actually pay the bill doesn’t matter on the accrual basis!

So we restated my client's financial statements, and I reviewed the new income statement with the team. The team liked the fact that June, July and August were now shown as their busiest months. They agreed that the restated financial statements reflected the true economic activity of their business, and they found far more value in reviewing them in their restated form.

Accrual Basis

The biggest change in going from cash basis to accrual basis is that you need to learn about Accounts Receivable and Accounts Payable. Accounts Receivable (AR) means the total amount of money that your customers owe you. That is, it’s the total of all of the invoices you have sent to your customers for which they have not yet paid you.

Conversely, Accounts Payable (AP) means the total amount of money that you owe your vendors. That is, it’s the total of all of the bills you have received from your vendors that you have not yet paid.

If you’re using the cash basis, you don’t record AR or AP. You’re just waiting until you get paid or you pay your vendors. But once you start recording AR and AP, you will be preparing your financial statements on the accrual basis, and you will find them much more useful in helping you understand the economic activity of your business.

Hope that helps. Email me if you have any comments.

Roger

 

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