Example of Cash versus Accrual Accounting

The selection of an appropriate accounting method, both for financial reporting and for tax purposes is a very important decision for a business.   Once a method has been chosen, it is difficult to change, particularly for tax purposes.

There are quite a number of accounting methods that can be used, and that might be appropriate for a particular business enterprise.  The most common are cash basis and accrual basis.

Under the cash basis, revenues and expenses are recognized when payment is made or received. Under the accrual basis, revenues and expenses are recognized when they are earned.  To clarify this, a simple example is presented below.

For illustration purposes, assume the following facts (a real-world example would be much more complicated):

1. A new architectural professional service business has fixed costs of $5,000 per month all of which must be paid in cash.

2. It starts with $15,000 in cash invested by the owner and does not need to spend any money on equipment, deposits, or initial supplies.

3. It is fortunate and lands a good contract for architectural design services which will cost it $10,000 per month in salaries and other direct costs for 10 months ($100,000 total).

4. The client will pay the firm $16,000 per month for 10 months ($160,000 total). Payment is on the basis of billing the first of each month for the prior month's services and the client has 45 days to pay.

 
The following projections for the first 5 months (cumulative year-to-date) are in thousands of dollars and based on the above facts.

Month               1       2       3        4       5

ACCRUAL BASIS PROFIT & LOSS (% Completion Basis)

Sales              16      32      48       64      80
Variable costs    (10)    (20)    (30)     (40)    (50)
Fixed costs       ( 5)    (10)    (15)     (20)    (25)
Profit              1       2       3        4       5

ACCRUAL BASIS BALANCE SHEET

Cash                0     (15)    (14)     (13)    (12)
Accounts receivbl  16      32      32       32      32
Total Assets       16      17      18       19      20

Initial investment 15      15      15       15      15
Current profit     1       2       3        4       5
Total Equity       16      17      18       19      20

CASH BASIS PROFIT & LOSS

Sales               0       0      16       32      48
Variable costs    (10)    (20)    (30)     (40)    (50)
Fixed costs       ( 5)    (10)    (15)     (20)    (25)
Profit            (15)    (30)    (29)     (28)    (27)

Beginning cash     15      15      15       15      15

Ending cash         0     (15)    (14)     (13)    (12)

In other words, although accrual basis accounting shows the business as making steady profits of $1,000 per month, the business is not going to be able to complete the contract - probably having to close the first week of the second month because it has run out of cash and cannot meet its payroll.

Note that we may be able to extend the payment of some of our costs, in which case the cash-basis costs would decline some, being replaced with accounts payable, a liability. If we are a service business, as in the example, these would probably be relatively small and would not effect the outcome.

Related items:
    Accounting Methods

© Copyright 1999 Raymond S. Kulzick. All rights reserved. 990923.