Cash Accounting Versus Accrual Accounting -

Date Written: 10/7/2022

Assignment: Write a 250 word essay on cash versus accrual accounting.

There are two main methods of accounting. One is cash accounting the other is accrual accounting. The question is which one is better? The first option, cash accounting, is straightforward and easy to use. Under this method, sales are recorded when cash comes in and expenses are recorded when cash goes out. One major downside to this method is that sometimes it doesn’t accurately reflect the economic reality of the situation.

Let’s consider an example. Dan runs a bicycle store. His lease requires him to prepay his rent for the next three months at the beginning of every quarter. Therefore he would pay for the rent of January, February, and March in January. If Dan used the cash method, then his net income in January will be far lower than in February or March, even if his sales and other expenses are the same in the other months. If potential investors looked at his financial statements, then they would suspect his profitability to have wild fluctuations. Unfortunately, this is not the reality of the situation.

Accrual Method

The second option, accrual accounting, makes up for the shortcomings of the cash method. Using this method, revenue is recorded as soon as goods or services are delivered, even if cash hasn’t been received. Similarly, expenses are recorded when goods or services are received, regardless of whether they have been payed for yet. Now let’s consider the example above but use the accrual method of accounting. On January 1st Dan pays $6,000 for the rent of January, February, and March. At this point he would add $6,000 in prepaid rent to his assets account. This $6,000 will be eliminated over the next three months as the expense is recorded. Therefore at the end of every month he adds $2,000 to his expenses account and this is payed by the prepaid rent. Now Dan’s rent expense will be accurately distributed over the the three months.

Both methods above have some merit, but the accrual method is clearly superior. This is because the accrual method is far more accurate than the cash method. This is why the accrual method is better than the cash method.