Cash v. Accrual Accounting

Lesson

Cash accounting records transactions when cash is exchanged, while accrual accounting records transactions when they are incurred, regardless of when cash is exchanged. Understanding these differences is crucial for financial reporting and decision-making.

Practice Question #1

Which accounting method records transactions when they are incurred, regardless of when cash is exchanged?

A) Cash Accounting

B) Accrual Accounting

C) Cash Flow Statement

D) Revenue Recognition

Select an option above to see an explanation here.

A) Cash accounting records transactions when cash is exchanged. B) Accrual accounting records transactions when they are incurred, regardless of when cash is exchanged. C) The cash flow statement shows the inflows and outflows of cash during a specific period. D) Revenue recognition records revenue in the financial statements when it is earned.

Terms

Cash Accounting:: A method of accounting where transactions are recorded when cash is received or paid.
Accrual Accounting:: A method of accounting where transactions are recorded when they are incurred, regardless of when cash is exchanged.
Revenue Recognition:: The revenue is recorded in the financial statements when earned, not necessarily when cash is received.
Expense Recognition:: The process of recording expenses in the financial statements when they are incurred, not when cash is paid.
Accounts Receivable:: Money owed to a company by its customers for goods or services provided on credit.
Accounts Payable:: Money a company owes its suppliers for goods or services received on credit.
Prepaid Expenses:: Expenses paid in advance for goods or services that will be received.
Unearned Revenue:: Money a company receives for goods or services that still need to be provided.
Generally Accepted Accounting Principles (GAAP):: A set of accounting standards and guidelines for preparing financial statements.

Practice Question #2

What is the term for money owed to a company by its customers for goods or services provided on credit?

A) Accounts Receivable

B) Accounts Payable

C) Prepaid Expenses

D) Unearned Revenue

Select an option above to see an explanation here.

A) Accounts receivable is money owed to a company by its customers for goods or services provided on credit. B) Accounts payable is money a company owes its suppliers for goods or services received on credit. C) Prepaid expenses are expenses paid in advance for goods or services that will be received in the future. D) Unearned revenue is money a company receives for goods or services that still need to be provided.

Historical Example

In the late 1980s, a major retail company switched from cash accounting to accrual accounting. This change led to a significant increase in reported revenue and net income, as the company was now recognizing revenue when it was earned, rather than when cash was received. This change was widely covered in major newspapers and highlighted the importance of understanding the differences between cash and accrual accounting.

Practice Question #3

Which of the following is NOT a difference between cash and accrual accounting?

A) Revenue recognition

B) Expense recognition

C) Cash flow statement

D) Accounts receivable and payable

Select an option above to see an explanation here.

A) Revenue recognition is a difference between cash and accrual accounting, as cash accounting records revenue when cash is received, while accrual accounting records revenue when earned. B) Expense recognition is a difference between cash and accrual accounting, as cash accounting records expenses when cash is paid, while accrual accounting records expenses when they are incurred. C) The cash flow statement is not a difference between cash and accrual accounting, as it is a separate financial statement that shows the inflows and outflows of cash during a specific period. D) Accounts receivable and payable are differences between cash and accrual accounting, representing money owed to or by a company for goods or services provided on credit.

Real-World Example

A small business owner provides services to a client in December but does not receive payment until January. Under cash accounting, the revenue would be recorded in January when the payment is received. However, under accrual accounting, the revenue would be recorded in December when the service was provided.