Cash basis accounting versus accrual accounting

Bookkeeping methods for managing the balance sheet and other books of a business or household include the cash basis method and the accrual method.

With the cash basis method of accounting, expenses are accounted for as they paid, and revenues are accounted for when they are received.  This method is simpler to administer but portrays a less accurate picture of the financial condition of the business or household.

With the accrual accounting method, expenses are accounted for as they are incurred, and revenues are accounted for when they are earned.  This method is more complex to administer and track but provides a more accurate picture of the financial condition of the business or household at any point in time.

The accrual accounting method gives a more accurate picture of the financial condition of a business, as it removes any inaccuracies in the balance sheet related to expenses being paid late and revenues being received early.

In order to illustrate the difference between these two methods, consider an example where an insurance policy’s annual premium is paid in advance.  In this scenario, the premium would be booked as an expense in one lump amount when the cash basis method is used.  Should the accrual method be used, the annual payment would remain on the balance sheet as a prepaid expense and would be amortized over the duration of the annual term.

Consider, similarly, revenue received in advance for a contract which is 3 months in duration.  Should the cash method be used, this revenue would be booked in one lump sum.  Should the accrual accounting method be used, the revenue would be booked piecemeal over the three month contract period.

As can be seen from both of these examples, the accrual method is a more accurate method in terms of describing the financial state of the business or household because it takes into account the effect of revenue received but not yet earned, and expenses paid but not yet accrued.