5350.024 Accrual vs. Cash
There are two different methods of accounting: accrual and cash basis.
Cash Basis:
This is like writing down only when you actually get or spend money.
- One day, you sell $3 worth of lemonade and get the money in your hand. You write down “$3 earned.”
- But the day before, you bought $5 worth of lemons and sugar from the store, but you promised to pay for it later (you haven’t given the money yet). So, you don’t write down anything for the lemons because no money has left your pocket.
At the end of the day, you see $3 in your pocket and think, “I made $3!”
Accrual Basis:
This is like writing down both when you promise to get or spend money, even if it hasn’t happened yet.
- You sell $3 of lemonade, so you still write down “$3 earned.”
- But, even though you haven’t paid for the lemons yet, you promised to give the store $5. So, you write down “-$5 spent” because it’s something you owe.
At the end of the day, you look at your notes and think, “Oh no, I made $3, but I still owe $5, so I’m down by $2.”
What’s the Difference?
- Cash Basis is like thinking, “How much do I have in my pocket right now?”
- Accrual Basis is like thinking, “What’s really happening with my money, even if I haven’t paid or received it yet?”
In the cash basis, you think you made money because you don’t count the lemons you haven’t paid for. In the accrual basis, you know you still owe for those lemons, so it looks like you lost money.
Both ways are important because the cash basis shows what you have right now, and the accrual basis shows the full picture of what you owe or are owed.
Most restaurants use accrual accounting because it provides a clearer long-term view of the business’s financial position. However, it’s useful to understand both methods, as each has its place in financial management.
Scenario:
- On January 15, the restaurant purchased $5,000 worth of ingredients on credit, meaning they haven’t paid for it yet but will owe this amount in the future.
- On January 16, the restaurant made $3,000 in sales, and these sales were paid for in cash.
Cash Basis Accounting:
Cash basis accounting records transactions only when cash is actually received or paid out. In this method:
- Revenue is recorded only when the cash is received.
- Expenses are recorded only when the payment is made.
In this case:
- Sales Revenue: The restaurant received $3,000 in cash from sales, so this amount is recorded as revenue.
- Cost of Goods Sold (COGS): Since the $5,000 purchase of ingredients was made on credit and no cash has been paid yet, this expense is not recorded in cash basis accounting at this time.
- Operating Expenses: No other expenses (such as payroll or utilities) were paid in cash, so nothing is recorded here.
Thus, the Net Income under the cash basis is $3,000, because no expenses were actually paid during this period.
Cash Basis: The income statement reflects only the cash transactions. In this case, $3,000 in cash sales is recorded, and since no cash expenses have been paid, the net income is $3,000.
Cash Basis Income Statement
Description | Amount ($) |
Sales Revenue | 3,000 |
Cost of Goods Sold (COGS) | 0 |
Operating Expenses | 0 |
Net Income | 3,000 |
Accrual Basis Accounting:
Accrual basis accounting records revenues and expenses when they are earned or incurred, regardless of when the cash is actually received or paid.
In this case:
- Sales Revenue: The restaurant earned $3,000 from sales, and it is recorded even though the sale was in cash.
- Cost of Goods Sold (COGS): The restaurant incurred an expense of $5,000 when it purchased ingredients on credit. Under accrual accounting, this expense is recognized even though payment hasn’t been made yet.
- Operating Expenses: There are no additional operating expenses in this example.
Thus, the Net Income under accrual accounting is -2,000 (a loss), because the restaurant recognized both the $3,000 in revenue and the $5,000 in expenses incurred, resulting in a $2,000 deficit.
Accrual Basis: This statement records all transactions, including credit purchases. Here, the sales revenue of $3,000 is recognized, but the cost of goods sold (COGS) of $5,000 (purchased on credit) is also recognized, resulting in a net income of -$2,000 (a loss due to the credit purchase being recognized as an expense).
Accrual Basis Income Statement
Description | Amount ($) |
Sales Revenue | 3,000 |
Cost of Goods Sold (COGS) | 5,000 |
Operating Expenses | 0 |
Net Income | -2,000 |
Summary:
- Cash Basis: Only recognizes transactions when cash changes hands, showing a profit of $3,000 because no expenses were paid yet.
- Accrual Basis: Recognizes revenue and expenses when they are incurred, showing a loss of $2,000 because the $5,000 expense for ingredients is recorded as soon as it’s incurred, even though it hasn’t been paid yet.
This example shows how the timing of recording transactions differs between the two methods, and how cash flow can look positive on a cash basis, but the business might still be incurring significant expenses on an accrual basis.
Accounting Basics Worksheet: Cash vs. Accrual Accounting
Instructions:
Fill in the definitions for the following key concepts based on what you’ve learned. Use clear and simple explanations. If you need help, refer to your course materials.
- Cash Basis Accounting
Definition:
In your own words, explain what cash basis accounting is and how it works. - Accrual Basis Accounting
Definition:
In your own words, explain what accrual basis accounting is and how it works. - Sales Revenue
Definition:
What does “sales revenue” mean? How does it show up in both cash basis and accrual basis accounting? - Cost of Goods Sold (COGS)
Definition:
What does COGS represent in a restaurant’s financials, and how does it differ in cash vs. accrual accounting? - Net Income
Definition:
What does net income mean, and how is it calculated in both accounting methods? - Practice Problem
Use this space to solve the following scenario:
“On January 15, a restaurant buys $500 of ingredients on credit. On January 16, the restaurant earns $300 in cash from food sales. Explain how the restaurant would record these transactions using cash basis and accrual basis accounting.”
- Cash Basis:
- Accrual Basis:
Answer Key
- Cash Basis Accounting
Definition:
Cash basis accounting is when transactions are recorded only when cash is received or paid. For example, revenue is recorded when the money is received, and expenses are recorded only when the cash is actually paid out. This method is simple but doesn’t always show the full picture of what a business owes or is owed. - Accrual Basis Accounting
Definition:
Accrual basis accounting is when transactions are recorded when they are earned or incurred, regardless of when cash is exchanged. This means that revenue is recorded when it’s earned (even if the payment hasn’t been received yet), and expenses are recorded when they are owed (even if they haven’t been paid yet). This method provides a more accurate view of a business’s financial health. - Sales Revenue
Definition:
Sales revenue is the total amount of money a business earns from selling goods or services.
- In cash basis accounting, sales revenue is recorded when the cash is received.
- In accrual basis accounting, sales revenue is recorded when the sale is made, even if the cash hasn’t been received yet.
- Cost of Goods Sold (COGS)
Definition:
COGS represents the direct costs of producing the goods sold by the business, such as ingredients for a restaurant.
- In cash basis accounting, COGS is recorded when the cash is actually paid for the goods (e.g., when the restaurant pays for ingredients).
- In accrual basis accounting, COGS is recorded when the expense is incurred (e.g., when the restaurant takes delivery of the ingredients, even if they haven’t paid for them yet).
- Net Income
Definition:
Net income is the total profit (or loss) a business makes after subtracting all expenses from its total revenue. It reflects the final financial result for a specific period.
- In cash basis accounting, net income is calculated using only cash that has actually been received and paid out.
- In accrual basis accounting, net income includes all earned revenues and incurred expenses, even if the cash hasn’t changed hands yet.
- Practice Problem
“On January 15, a restaurant buys $500 of ingredients on credit. On January 16, the restaurant earns $300 in cash from food sales. Explain how the restaurant would record these transactions using cash basis and accrual basis accounting.”
- Cash Basis:
- January 15: No transaction is recorded because the restaurant has not paid for the ingredients yet.
- January 16: The $300 cash sale is recorded as revenue.
- Net Effect: $300 revenue recorded, $0 in expenses.
- Accrual Basis:
- January 15: The $500 purchase of ingredients is recorded as an expense, even though the restaurant hasn’t paid yet.
- January 16: The $300 cash sale is recorded as revenue.
- Net Effect: $300 revenue recorded, $500 expense recorded, resulting in a $200 loss.