Cash Accounting vs. Accrual Accounting: Overview

While US GAAP dictates that accrual accounting is the appropriate method of accounting for external purposes, there may be times when you run into a scenario where the bookkeeper is using cash accounting. Here is a quick look at the differences between these two accounting mindsets.

ACCRUAL ACCOUNTING

Accrual accounting is the US GAAP accounting that we learn in most academic settings. Revenues are recorded when they are earned–when the company has satisfied a specific obligation, such as providing a service (service revenue), allowing an individual to live in a rented space for a specific amount of time (rent revenue), or allowing a borrower to hold and use money for a certain amount of time (interest revenue). 

Expenses on the other hand are recorded as incurred, matching the expense in the period in which the related revenue was recorded.  For example, we record rent expense in the period in which we had use of the building–even if we pay for the rent in a different month.

CASH ACCOUNTING

Cash accounting on the other hand is much more simplistic. Cash accounting assumes that we record revenue when the related cash is collected and record expenses when the cash is paid. This can lead to a major difference in revenue, expense, and net income calculations under these two methods.

To clarify, let’s imagine that at the beginning of 20X1 we sign a commercial lease with our landlord, agreeing to rent of $2,000 a month for 36 months. Our landland, however, would only sign the lease if we agreed to pay the 36 months rent up front, causing us pay the landlord $72,000 at the beginning of 20X1 for rent. 

Under the the cash method, this entire $72,000 would be rent expense in 20X1, and since we already recorded the expense in this year, we would have no rent expense in 20X2 and 20X3. 

[Cash accounting image] – TBD

Under the accrual method, however, we understand that we will be using this space during the next three years to generate revenues, so we would record the rent expense for each year as appropriately incurred. 

[Accrual accounting image] – TBD

If you are studying accounting or planning on practicing in accounting one day, it is important to have a strong understanding of these differences. Try some of the cash accounting vs. accrual accounting practice scenarios below to test your understanding of the differences. 

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Click the button below to start the first lesson: Cash to Accrual Conversions.