What Is the Cash Method of Accounting?
The normal method for reporting a company’s financial results is the accrual basis of accounting, under which expenses are matched to revenues within a reporting period. However, for tax purposes, it is sometimes possible to report income under the cash method of accounting. Under this approach, revenue is not recognized until payment for invoices is received, while expenses are not recognized until paid.
The cash basis of accounting can result in a great deal of manipulation from the perspective of the Internal Revenue Service (IRS), which discourages its use but does not prohibit it. For example, a company may realize that it will have a large amount of income to report in the current year and will probably have less in the following year. Accordingly, it prepays a number of supplier invoices at the end of the year, so that it recognizes them at once under the cash method of accounting as expenses in the current year.
The IRS prohibits this type of behavior under the rule that cash payments recognized in the current period can only relate to current-year expenses. Nonetheless, it is a difficult issue for the IRS to police. Manipulation can also occur by delaying billings to customers near the end of the tax year. If business surges suddenly at the end of the tax year, cash-based accounting will not reveal sales until the following year, since payment may not arrive until then. As a result, the cash method tends to underreport taxable income.
The IRS prohibits its use if a company has inventories on hand at the end of the year. Expenditures for inventory can be so large and subject to manipulation that a company could theoretically alter its reported taxable income to an enormous extent. The cash basis is also not allowable for any C corporation, partnership with a C corporation as a partner, or tax shelter.
Within restrictions, it is allowable for entities with average annual gross receipts of $5 million or less for the three tax years ending with the prior tax year, as well as for any personal service corporation that provides at least 95 percent of its activities in service areas.
The IRS imposes some accrual accounting concepts on a cash-basis organization to avoid blatant income avoidance. For example, if a cash-basis company receives a check at the end of its tax year, it may be tempted not to cash it until the beginning of the next tax year. To prevent this, the IRS uses the concept of constructive receipt, which requires the receipt to be recorded when it is made available without restriction.
What Is the Accrual Method of Accounting?
Under the accrual method of accounting, a transaction is recorded when it occurs, even if no cash changes hands. You record such transactions with an accrual, which allows an entity to record expenses and revenues for which it expects to expend cash or receive cash in a future reporting period.
Examples of accruals are:
- Revenue accrual: A consulting company works billable hours on a project that it will eventually bill to a client for $5,000. It can record an accrual in the current period, so that its income statement shows $5,000 of revenue, even though it has not yet billed the client.
- Expense accrual: interest: A company has a loan with a local bank for $1 million and pays interest at a variable rate. If the bank invoice for $3,000 in interest arrives the following month, the company accrues the expense so the amount is shown on its income statement in the proper month.
- Expense accrual: wages: A company pays employees at the end of each month for hours worked through the 25th. To fully record wages for the month, it accrues $32,000 in additional wages, representing the cost of work for the remaining days.
In double-entry bookkeeping, the offset to an accrued expense is an accrued liability account, appearing in the balance sheet. The offset to accrued revenue is an accrued asset account, such as unbilled consulting fees, which also appears in the balance sheet.
Most accruals are initially created as reversing accruals, so the accounting software automatically cancels them in the following month. This happens when you are expecting revenue to be billed or supplier invoices to arrive the next month.
What Is Double-Entry Bookkeeping?
Double-entry bookkeeping is the classic system of recording financial transactions. All transactions are recorded twice, using a debit and a credit.
- A debit increases an asset or expense account, or decreases a liability or equity account. It is positioned to the left in an accounting entry.
- A credit increases a liability or equity account, or decreases an asset or expense account. It is positioned to the right in an accounting entry.
Example Transactions
Travel Expense
| Debit | Credit |
|---|---|
| Travel expense | 1,000 |
| Cash | 1,000 |
In this entry, cash (an asset) decreases by $1,000 while travel expense increases.
Computer Purchase
| Debit | Credit |
|---|---|
| Computer equipment | 10,000 |
| Cash | 10,000 |
Here, cash decreases by $10,000 while a new asset (computer equipment) increases.
Automobile Purchase on Credit
| Debit | Credit |
|---|---|
| Fixed assets—Vehicles | 25,000 |
| Accounts payable | 25,000 |
This records the purchase of an automobile for $25,000, with payment due later.
Paying Off Supplier’s Invoice
| Debit | Credit |
|---|---|
| Accounts payable | 25,000 |
| Cash | 25,000 |
This entry clears the liability by paying the supplier, reducing both cash and accounts payable.