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.
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 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 inco