Question

Explain the differences between the cash and accrual accounting method. Which method do physician offices usually use for their financial reporting?

Answer 1

Cash Basis of accounting

1. It is a method of recording transactions in which the revenues, expenses, assets and liabilities are reflected in their respective accounts during the period when the actual receipts or actual payments are made.
2. It is method of accounting where the transactions are recorded for the accounting period when the actual cash is received or paid.
3. No journal entry is made when the payment or receipt is due.
4. Governments generally follow cash basis of acccounting while financial reporting.
5. Certain Professsional people record their accounting transactions on cash basis. For the purpose of recording income, they use cash basis. However, for the recording of expenditure they take into account outstanding expenses also. Hence, the income statement prepared by the people belonging to certain professions, is also known Receipts & Expenditure Account.
6. The micro sized businesses which do not have large cash flows follow this method accounting.
7. This method is less holistic since it records only the cash transactions.
8. Its less accurate method of transaction since it does'nt take into account all the transactions. It might give a false picture of the financial health of the company which is earning huge amount of cash but have a large ammount of accounts payable also that exceeds the company's cash inflow. Thus the investor would be under false impression that the concern is earning profits whereas in reality it running under losses.
9. Since the income is not recorded untill received in cash, hence the business gets tax advantage because it is not taxed, untill the money enters the bank account.
10. As per the IRS criteria, other than a S-corp, if a business concern earns more than $25 million dollar in gross reciepts for the accounting period, it should follow accrual method of accounting. Otherwise the business may follow cash basis accounting.
11. Small businesses or sole prorietorships which do not carry much inventory can follow cash basis accounting.
12. It follows single-entry system.

Accrual Basis Accounting

1. It is a method of recording transactions in which the assets, liablities, revenues & expenses are reflected in their respective accounts for the period in which they accrue. This method of accounting is also known as mercantile system of accounting.
2. In this method the transaction entries are made for the period in which the amounts are due for payment or receipt.
3. Accrual basis accounting method is based on the logic that when a transaction or an event has actually occurred, its consequences can not be avoided, hence, the real picture of the transaction must be recorded in the books of accounts in the form of either profits earned or losses suffered, thus depicting the real financial position of the business concern for the particular accounting periood.
4. Accrual basis accounting is always considered better than cash basis accounting since it include all the transactions that have actually occurred during an accounting period.
5. Accrual basis accounting is followed by most of the commercial & industrial establishments.
6. The small, medium & large size businesses which have significant cash flows follow this method.
7. This method of accounting is more holistic in approach since it takes into account all transactions for the period.
8. It is more accurate method of accounting. It includes all the accounts receivables & payables i.e. it records all the revenues when they are earned and all the expenses when they are incurred. Hence, this method gives the real picture of the financial health of the company.
9. Using accrual accounting, if a business gives invoice to his customer of $10000 for the year 2019, it records the transaction in 2019 & thus pay taxes for the income, although it receives the cash in 2020. Hence there is no tax advantage associated with this metthod.
10. The businesses which carry large amount of inventory should follow accrual method.
11. It follows double-entry system.
12. This method of accounting is recognized by both GAAP & IFRS. Businesses that follow GAAP are required mandatorily to follow accrual method of accounting.

Some of the criteria of distinction between accrual basis & cash basis accounting are as follows :-

Criteria of Distinction	Cash Basis Accounting	Accrual Basis Accounting
Prepaid/outstanding Expenses in the balance sheet	In this method, there are no prepaid/outstanding expenses recorded.	In this method there may be prepaid/ outstanding expenses in the balance sheet
Accrued/unaccrued income in the balance sheet	No accrued/unaccrued income recorded.	There may be accrued/unaccrued income recorded.
Higher/lower income in case of prepaid expenses or accrued income	The income statement prepared under this method always shows lower income	The income statement will show higher income.
Higher/lower income in case of outstanding expenses or unaccrued income	The income statement will show relatively higher income.	Income statement will show lower income as compared to that prepared under the cash basis.
Recognition under the Companies Act	Not recognised by the Companies act	Recognised by the Companies Act.
The availability of several accounting method options (like FIFO, LIFO, SLM, WDV) for the accountant to record the transactions.	Under this the accountant cannot make any choice of accounting method as such.	The accountant has the freedom to choose the suitable accounting method.

Example :-

A firm closes its book of accounts on 31st December ever year. A sum of $500 has been due for payment on account of rent for the year 2018. The amount has been paid in January, 2019.

Now, if the firm is folllowing cash basis accounting method, no entry for the due amt. of rent would be made in the book of accounts for the year 2018. It would only be recorded in Jan, 2019 when the actual payment is made.

However, under accrual method of accounting two entries would be made, they are :-

1. On 31st December, 2018, the rent a/c would be debited while the landlord's a/c would be credited by the outstanding rent amt. of $500.
2. In January, 2019, the landlord a/c would be debited & the cash a/c would be credited with the rent amt. $500 actually paid.

Although accrual method of accounting is better financial reporting practice as compared to cash basis accounting, smaller businesses including certain professions such as Physicians /Medical Practitioners prefer cash based accounting method for their financial reporting purpose. The IRS allows the health care businesses to follow cash- basis accounting based on the following criteria :-

• If the annual gross receipt of the business concern is less than $5 million, it is allows to use the cash basis accounting method.
• If the firm qualifies as Personal Service Corporation i.e. if the firm has 95% of its employees performing health-care services & 95% of its business operations include providing health care services.