Cash Versus Accrual Accounting

And the business still has $2,500 in merchandise for resale on its shelves, but the business also has bills that have not been paid of $13,000 for merchandise for resale.

Cash accounting can give a prospective buyer a very distorted picture of the business’ overall financial situation.

Accrual Accounting:

With accrual accounting, expenses and sales are accounted for at the time that they occur whether or not any funds have actual exchanged hands. The important phrase in the aforementioned sentence is; “at the time that they occur”. For clarification, any and all sales are actually accounted for when invoices are presented (in the case of a retailer the invoice is the sales receipt from the cash register) or mailed to customers and expenses are actually accounted for when invoices (bills) are received by the business not the date when they are paid.

If we look at the previous examples, the financial statements would appear quite different if the business utilized accrual accounting methods. In the first case there would be more than just the Profit and Loss statement there would be the two additional statements; Balance Sheet and Utilization of Cash.

The usual presentation of a set of accrual financial statements is Balance Sheet first, followed by the Profit & Loss statement followed by the Utilization of Cash. However, in order to show you the difference between the two accounting methods I will show the Profit & Loss statement first, then the Balance Sheet, followed by the Utilization of Cash.

I am using the identical scenario with respect to sales and expenses that I presented with the cash accounting method above.

Profit & Loss statement at the end of the 1st day:
Sales Cost of Goods Sold Gross Margin Expenses - Rent Profit (Loss)	$ 1,000 500 500 1,000 $ (500)
Balance Sheet at the end of the 1st day:
Assets Cash Inventory Total Assets Liabilities Shareholders' Equity	$ 8,000 1,500 9,500 0 $ 9,500
Utilization of Cash statement at the end of the 1st day:
Cash Received Sales Cash Expended Cost of Goods Sold Rent Inventory Cash beginning of period Cash at end of period	$ 1,000 500 1,000 1,500 10,000 8,000

 

 

Profit & Loss statement at the end of the 1st month:
Sales Cost of Goods Sold Gross Margin Expenses - Rent Profit (Loss)	$ 25,000 12,500 500 1,000 $ 11,500
Balance Sheet at the end of the 1st month:
Assets Cash Inventory Total Assets Liabilities Shareholders' Equity	$ 19,000 2,500 21,500 12,500 $ 9,000
Utilization of Cash statement at the end of the 1st month:
Cash Received Sales Cash Expended Cost of Goods Sold Rent Inventory Cash beginning of period Cash at end of period	$ 25,000 12,500 1,000 2,500 10,000 19,000

The difference in the Profit and Loss Statements between cash and accrual accounting at the end of the first month is quite remarkable. The cash accounting method would show a profit of $22,000 whereas the accrual accounting method would show a profit of $11,500, which is really the correct number. It is much easier to determine the financial health of a business by looking at financial statements that have been prepared utilizing the accrual accounting method compared to financial statements that were prepared utilizing the cash accounting method.