Cash basis vs Accrual basis in terms of revenues and expenses
- Now we compare the contrast in the cash basis accounting vs the accrual basis accounting. What are these accounting system??These are 2 different types of accounting methods by which company can maintain their records. How does company know which one of the method is used? It depend on the individual circumstance.
- But as a broad guide line the smaller company or service company trend to use cash basis accounting. The larger company and the company that are selling inventories or maintain inventories trend to use accrual basis accounting. So let’s get right into (start immediately) an example to help us better appreciate to understand the differences between 2 methods.
- So in the example here in the month of February, CPA (Certified Public Accountant) goes out to secure (maintain) client, and completed work for them in the amount of Rp.5,000,000. He does all of them in the month of February. He send invoice also in the month of February, giving 30 days payment term.
- Then we enter the month of March. In the month of March CPA receive all of this Rp.5,000,000 from his client for the work completed in February. Also in the month of March CPA is unable to find additional work. So he does absolutely no work in March.
- So the question is which month does the CPA recognize the revenue? To answer the question, let’s assume for a moment CPA maintain his own book on the cash basis. If the CPA would maintain his book on the cash basis, then in the month of February he records absolutely no revenue. But in the month of March he records Rp.5,000,000 worth of revenue. What is the basis for the revenue recognition? The basis is in the guideline that I have provided you, when did the CPA receive the money?, that’s the question you need ask yourself. As you can see in the month of February he receive no money. So therefore his revenue is zero. But in the month of March he receive Rp.5,000,000 of cash, so his revenue in the month of March is Rp.5,000,000.
- In the accrual basis, which month does he recognize his revenue? In the month of February he will recognize his Rp.5,000,000 revenue. In the month of March his revenue recognition would be zero. Why is that? When did the CPA earn this money? The CPA would have earned the money in the month that he completed the work. So in this example CPA completed the work and therefore earn the money in February, which is why (that’s why) we record revenues of Rp.5,000,000 in February. But in the month of March he did not earn any money.
- So in the conclusion with cash basis accounting, revenues are recognized in the month in which you receive the money regardless of when you earned it. However under the accrual basis accounting revenues are recognized in the month in which you earned it regardless of when you receive the cash.
- So that concludes a discussion on the revenue aspects (point of view) of cash basis accounting vs accrual basis accounting.
- When you first start the company, you can keep your book on the cash basis accounting or accrual basis accounting. How do you know which method to use? In this discussion we will talk about expenses. The CPA rent office space for Rp.10,000,000 per month.
- In the month of February CPA is unable to pay his office for rent. However in the month of March he doubles up this and pays Rp.20,000,000 of rent, that are Rp.10,000,000 to catch up for February which has passed you, and Rp.10,000,000 for current month of March. Which month is rent expense going to be recognized?
- Under the accrual basis accounting, the CPA picks up Rp.10,000,000 of rent expense in February and Rp.10,000,000 of rent expense in the month of March. Which month was the rent expense incurred (got)? Each of the month of February and March, CPA has incurred an obligation to pay the rent of Rp.10,000,000.
- Under the cash basis method, expense are recognized in the month in which the expense was actually paid. Under the accrual basis method, expense are recognized in the month in which the company incurs the obligation to pay regardless of when they actually paid it.