Question

How does cash basis accounting differ from accrual basis accounting? Which gives a more accurate picture of the profitability of a company and why?

Answer 1

The difference between the two types of accounting is when revenues and expenses are recorded. In cash basis accounting, revenues are recorded when cash is actually received and expenses are recorded when they are actually paid (no matter when they were actually invoiced). In accrual basis accounting, income is reported in the fiscal period it is earned, regardless of when it is received, and expenses are deducted in the fiscal period they are incurred, whether they are paid or not. In other words, using accrual basis accounting, you record both revenues and expenses.

The result of accrual accounting are income statement that better measures the profitability of a company during a specific time period; and a balance sheet that better shows the financial condition of the company.Accrual basis financial statements do a better job of matching revenues with expenses for a particular time period. The income includes sales for which you have done the work haven't yet been paid (your receivables) and the expenses include expenses incurred for the period that you have not yet paid (payables). It gives a more accurate picture of the actually costs and revenues associated with the time period you are looking at because with cash basis it would be skewed by when the cash was received or paid out. Accrual basis accounting is the method of accounting most businesses and professionals are required to use by law.