There are two primary methods of accounting: cash basis and accrual. While public corporations are required to use accrual accounting, financial statements include both types. The income statement and balance sheet flow from accrual accounting while the statement of cash flows is a cash accounting report. Investors analyzing a company should understand the difference between the two to best interpret what they read.
Cash Basis Accounting Defined
Cash basis accounting is easiest for most people to understand because it closely mimics individual accounting. Cash basis accounting is exactly what its name suggests: accounting for cash as it is received or spent. If you keep a checkbook or actively monitor your bank account, you use cash basis accounting.
Accrual Accounting Defined
Say a company makes 100 widgets in January and sells 60 of them that same month. The company accountant records the revenue from the sale of 60 widgets along with the costs and expenses associated with creating those 60. It accrues, or sets aside for later, the costs and expenses related to the other 40 widgets still in inventory. Accrual accounting also uses depreciation, lowering the cost value of assets like equipment and supplies as they are "used up."
Effect on Revenue Recognition
Accrual accounting closely associates revenue and expenses, so it's easy to see the profitability of business activities. Accruals account for each dollar of cost associated with making a dollar of revenue, including sales on credit that aren't actually in hand yet. Cash accounting is more about the process of business, since it shows the movement of revenue and expenses in and out of the business. It reflects the actual cash on hand that can be used to further the business at any time and identifies ongoing issues like a high percentage of delinquent bills.
Analyzing Financial Reports
The difference between cash and accrual accounting comes into play most within the cash flow statement and the income statement. Accrual accounting within the income statement speaks to how well the company manages its expenses and generates sales. The statement of cash flows may reveal the actual health of the company. While revenue is always good, cash in the bank — or the lack thereof — can make or break a company.
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