Cash Accounting, Accrual Accounting & Cash Flow Management
The cash basis method recognises income and expenses when cash is exchanged (either paid or received), regardless of when it is earned or incurred. The accrual basis method recognises income and expenses when earned or incurred, regardless of when cash is exchanged.
To illustrate, let's look at an example:
Your rent is BHD 1,000 per month payable every three months in advance.
Under the cash accounting method, you would pay (and recognise) BHD 3,000 as rent expense on 1 January, and zero rent in February and March.
Under the accrual accounting method, you would recognise the same transaction differently. You record several accounting entries (also called 'Journal Entries') as follows:
January - (i) cash outflow of BHD 3,000 (ii) rent expense of BHD 1,000; and (iii) prepaid rent of BHD 2,000.
February - (i) rent expense of BHD 1,000; and (ii) prepaid rent of BHD 1,000.
March - rent expense of BHD 1,000.
Why is this important?
Both methods have their relevance in business and their advantages and disadvantages.
Cash Accounting
The advantage of cash accounting is its simplicity. It only requires a basic level of accounting literacy. However, you should note that the cash accounting method does not comply with International Financial Reporting Standards (IFRSs), which is the basis for preparing financial statements for submission to authorities, banks for funding, etc. Another disadvantage is that cash accounting does not account for receivables and payables.
Accrual Accounting
Accrual accounting is more complicated. This method provides better management information by matching income and expenses. However, accrual accounting can lead to disastrous outcomes without accurate monitoring of the cash flow position. Perhaps this is the most crucial point of this discussion and a key takeaway.
Cash Flow Management
Improper cash flow management is a leading cause of business failure. Companies of all sizes fall into the trap of stretching their liquidity (cash) position. Smaller companies are particularly guilty.
For example, you run a business that enters into a contract with a Large Company. Your company have been pursuing this opportunity for some time, and everyone in your company is very excited to win the contract.
Contract terms as follows:
A) Contract amount BHD 24,000 for one year
B) Payment terms:
i) 25% on signing the contract
ii) 75% on completion
Using cash accounting, you would recognise income when cash is received and expenses when cash is paid. Immediately there is an issue in reflecting the financial health of your business by showing income only in January and December (which is the term of this specific contract).
Using accrual accounting, you would recognise income equally at the rate of BD 2,000 per month until you have recognised the entire contract amount, regardless of when you receive the actual cash in the company's bank account. For this particular business, accrual accounting makes more sense. However, there is a cash flow challenge. 75% of the income on this contract is received following completion, which means that the company has to fund this project. Let's suppose eight months into the project; the company has no liquidity (cash) to pay salaries, suppliers of equipment, etc. In this case, the company may have difficulty completing the contract, although the contract is forecasted to be profitable once complete and payment is received.
Takeaways
Using the cash accounting method is suitable for only the smallest of businesses such as a retail business, where delivery of products or services, and the related payment is instantaneous.
A growing business should use accrual accounting and pay particular attention to cash flow management.