Cash Vs Accrual System of Accounting
Cash System of Accounting:
In the cash system of Accounting or the cash basis, income is counted when cash is actually received and expense is counted when the cash is actually paid.
Example 1: If a firm sells goods worth $1,000 of which $800 is received by cash (cash sales) and $200 on account, the cash basis of accounting records only $800 as sales. When the balance of $200 is received, say the following month, $200 goes to the following month’s sale.
Example 2: If a firm purchases inventories worth $700 during a month and if the entire payment is not made during the month, $700 is not included in the cost of goods even if the sale takes place. Say, the firm makes the payment to the suppliers the following month, $700 is then recorded.
So, the cash method of accounting does not confirm with the matching principle where revenues should be matched against its respective expenses. To sum up, this method records revenues when cash is received and records expenses when cash is paid. This type of accounting may only be suitable to small petty cash businesses.
Accrual System of Accounting
In the Accrual System of Accounting or the accrual basis, income is recognized when the sale takes place and expense is recorded when it is incurred. This is irrespective of whether cash is received from the customer for sale or cash is paid to the suppliers for purchases.
Example 1: If a firm sells goods worth $1,000 of which $800 is received by cash (cash sales) and $200 on account, the accrual basis of accounting records the entire $1,000 as sales. When the balance of $200 is received in the following month, it does not affect sales, but reduces the accounts receivables that were created during sales.
Example 2: If a firm purchases inventories worth $700 during a month and if the entire payment is not made during the month, $700 is still recorded as purchases in the same month. The cost of inventories with respect to the goods sold is recorded to the Cost of Goods Sold a/c in the same month (perpetual system of recording inventory).
So, the accrual method of accounting confirms with the matching principle where revenues should be matched against its respective expenses. To sum up, this method records revenues when sale takes place and records expenses when it is incurred. This type of accounting is widely followed by companies worldwide.
Example: Comparison of Income:
Cash method:
Cash received – Cash paid :
(1st month) $800 - $0 -> $800
(2nd month) $200 - $700 -> ($500)
Accrual method:
Sales made – Expenses incurred:
(1st month) $1,000 - $700 -> $300
(2nd month) -> only the new sales and expenses incurred of 2nd month.
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