The comparison between cash basis accounting and accrual basis accounting can create a lot of confusion for first-time entrepreneurs and others who are not well acquainted with accounting principles. Often this is caused because accountants or finance individuals tend to use terminology that assumes an underlying knowledge of the interactions between these three financial statements.
Using a very simple example, I hope to describe the basic difference between cash basis and accrual basis accounting, along with where certain phrases such as “inventory generated cash this month” come from. Accrual Basis financial statements store items on the balance sheet in an effort to match revenues with expenses. Meanwhile, Strict Cash Basis financial statements simply show the increases and decreases in the cash accounts. Note: most cash basis financials are “modified” cash basis, which means there is a mix between strict cash basis and accrual basis financials. To avoid confusion, we will be discussing only strict cash basis financials.
Below is a basic diagram of four events that often occur in the accounting cycle of a company that buys and sells a product.
I have left out such items as operating expenses and other transactions to focus on what happens when you buy and hold inventory to be sold at a later date while extending payment terms to your customers.
Step 1: Product is received from a Vendor along with a Bill for the Product
Step 2: The Bill is paid
Step 3: Some of the Product held in Inventory is sold to a Customer on terms
Step 4: Payment is received from the Customer for the sale which occurred in Step 3
The three basic financial statements represent either a point in time or a period of time. The Balance Sheet represents a point in time and in this case will be used to identify balances at the end of the step described above. The Income Statement and Statement of Cash Flows represent a period of time and will be used to identify transactions that have occurred from the beginning of the step to the end of the step. For example, the Balance Sheet for Step 2 represents the account balances at the end of Step 2. The Income Statement for Step 2 represents the transactions that occurred from the end of Step 1 to the end of Step 2.
It might also help to have a product to think about during this example, let’s call it a FBOX. In this example, we buy FBOX units for $5 from our vendor and sell them for $12.50 each.
Now, let’s discuss the effect that these four steps have on the financial statements from a Cash and Accrual perspective. The next four diagrams show the three basic financial statements (Income Statement, Balance Sheet, and Statement of Cash Flows) with a column for Cash Basis and a column for Accrual Basis.
In the first step, the company receives $35 worth of product (seven FBOXs) and a Bill for $35 from the Vendor. When a product is received along with a Bill for the product, there is no impact on the Cash Basis financial statements. In fact, Cash Basis financial statements only change when cash moves in or out of the checking account. Accrual Basis statements, on the other hand, show the receipt of our FBOXs being placed in Inventory ($35 on the Inventory line) and the creation of a liability ($35 on the Accounts Payable line) because of the Bill that was received.
In the second step, the company pays the Vendor $35 against the Bill it received in Step 1. On both the Cash and Accrual statements, the amount of cash is reduced by $35 to show a new cash balance of $65. On the Accrual balance sheet, the Accounts Payable line is reduced by $35 to reflect payment of the Bill. Since the Cash statements did not have an Accounts Payable amount, the $35 which was paid to the Vendor for the product is shown on the Income Statement as Cost of Goods Sold. Since we have not yet sold any FBOXs, the expenses of the Cash Basis Income Statement are not aligned with the intended Revenue for the FBOXs the company has in its Inventory. Since the goal of Accrual Basis financial statements is to align revenue with cost of goods sold (the matching principle), Step 2 is the first example of how Cash Basis financials fail to meet the matching principle on the expense side.
Now, in the third step, the company sells some of the FBOXs on hand (four units or $20 of the $35 that was purchased from the Vendor) for a price of $50 (four units at $12.50 each) to a Customer who will pay at a later date (aka payment terms). Because cash is not being exchanged in Step 3, only the Accrual Basis financial statements show the effect of this transaction. On the Balance Sheet, Accounts Receivable is now $50 to show the outstanding Customer Invoice, Inventory is reduced by $20 to show a reduction in the amount of FBOXs now available, and Retained Earnings is increased by $30 based on the Net Income the company is recognizing. The Income Statement, which represents the period from the end of Step 2 to the end of Step 3, shows Net Sales of $50, Cost of Goods Sold of $20, and Net Income of $30. The Statement of Cash Flows for Accrual Basis combines the changes to the Income Statement and the Balance Sheet to show that there was no change in Cash.
Positive numbers on the Statement of Cash Flows represent the generation (or creation) of cash. In this step, there was $30 in profit (shown as Net Income) and $20 from the sale of Inventory (shown as Decrease in Inventory). This period (or step) should have generated $50 of cash for the company. However, the $50 that was generated was “loaned” to the Customer in the form of an Account Receivable (to be paid at a future date). Step 3 demonstrates the matching principle of Accrual Basis financial statements.
In the fourth and final step, the Customer pays the company $50 for the sale that occurred in Step 3. When the company receives the cash payment from the Customer, it is shown in the Cash Basis Balance Sheet as an increase in Cash of $50 and an increase in Retained Earnings of $50. The Cash Basis Income Statement shows the $50 receipt as Net Sales with no associated costs for the period. This leads to the $50 Net Income result and $50 increase in Retained Earnings on the Balance Sheet. Step 3 is the second example of how Cash Basis financials fail to meet the matching principle on the revenue side.
The Accrual Basis Financial Statements show the Balance Sheet change which increases Cash by $50 and decreases Accounts Receivable by $50. There is no activity for the period on the Accrual Basis Income Statement and a $50 Net increase in cash on the Statement of Cash Flows which came from Accounts Receivable.
At the end of Step 4, the Cash and Accrual financials would match if we had sold all the inventory purchased in Step 1. This misalignment between revenue and expenses is one reason why the IRS generally requires businesses that carry inventory to use the accrual method of accounting.
A challenge for small business owners and/or entrepreneurs is when they look at an Accrual Basis income statement for a profitable month and wonder why there is no cash in the bank account. As we can see from the example above, the purchase of additional inventory (e.g. for next month) or the loaning of money to customers (e.g. Accounts Receivable) can reduce the amount of cash in the account.
The example presented above describes the basic components of the operating cash cycle. Once the basics are understood, we can elaborate on what terms such as inventory days (Step 1 to 3), payable days (Step 1 to 2) and days of sales outstanding (Step 3 to 4) mean and how they impact the cash required as you grow your business.
Overall, Cash Basis or Accrual Basis is not a function of how transactions are entered, but it does have an effect how they are reported. While additional entries are required for Accrual Basis financial statements, all accounting is done on a transaction basis, so it is critical that the transactions are entered accurately. This will yield the most efficient and predictable presentation of results.