Accrual vs Cash…What’s the Difference?

The question of accrual vs. cash refers to the type of accounting method the business uses. It determines when income and expense are recognized (recorded) for tax or accounting purposes.  There are other accounting methods, but these two are by far the most widely used.  The cash method is the simplest. It gets its name from the fact that the only thing you have to do is follow the flow of cash.  Income is only recognized when cash is actually received. Expenses are only recognized when cash is actually paid. For purposes of this discussion, cash can be any type of payment such as currency, checks, and debit or credit cards.The accrual method on the other hand, recognizes income and expenses only when they are incurred.  Under this method, the timing of the cash receipts and payments are of no consequence.  Income is recorded when it’s earned, rather than when received. Expense are recorded when incurred, rather than when actually paid.  Now that you have the theory, let’s look at a simple example.

Little Susie, who has grown tired of her small allowance, decides to try her luck with a Kool-Aid stand.  She has managed to save $10 from her allowances and purchases Kool-Aid, sugar, and paper cups from her local grocery store.  Her table and other supplies she manages to find at home and sets up her business.  Her table is set up on a busy corner in residential Seattle. It’s a hot day and soon she has collected $20 from Kool- Aid sales.

Now imagine that little Susie’s ship is about to come in.  Suddenly, from around the corner, there appears a of couple dozen runners. They are followed by many, many more.  Unknown to her, she had set up her stand in the path of the Seattle Marathon!  It is an unseasonably hot day and the officials of the marathon neglected to buy enough Gatorade for the race.  Soon her stand is surrounded by thirsty runners.

Some have money but most do not.  The runners are quickly getting dehydrated and the officials must act fast. They ask little Susie if she will provide the runners with the Kool- Aid. They agree to pay her later for every cup that is consumed.

Little Susie agrees, but finds she has little cash for the large amount of supplies that are required.  She asks a local grocer if he will loan her $5,000 worth of Kool- Aid supplies.  The grocer agrees and by the end of the day Susie has another $30,000 of sales.  She also has a bit of an accounting problem on her hands.

Because of Susie’s income she is now required to file a tax return. She will have to decide on that initial return which method of accounting to use.  Under the cash method, even though she has made a total of $30,020 of income and has $5,010 of related expense, her taxable income is only $10.  This is because she only actually received $20 in cash and paid $10 in cash.  The remainder of the income and expense will not be recognized until she receives payment and pays for her supplies.

Under the accrual method of accounting the story is very different.  Even though she has not paid the grocer for the Kool- Aid, she still incurred the expense.  And even though she has not been paid for her sales, she still earned the income.  So under this method, all the income and expenses would be recognized for a net income of  $25,010.  The scary part is that she will actually owe tax on this amount even though she had not received most of it.

Now you may be asking why anyone in their right mind would decide to use the accrual method.  That’s a very good question!  The answer to that will be discussed in my next article entitled "Accrual vs Cash…Continued" which can be found here.

If you have suggestions for other articles, or would like a non-geek explanation of something else, leave a comment and I’ll do my best to make your question the subject of future post.

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