Cash vs accrual accounting are two methods of recording accounting transactions for a business. Although the two methods primarily relate to the recording of actual bookkeeping transactions, the same principles apply when preparing financial projections for a business.
Financial projections should always be prepared using the accrual basis of accounting …
Under the cash method of accounting transactions are recorded when cash is received or paid, under the accrual basis of accounting revenue is recorded when earned and expenses are recorded when incurred by the business.
It is important to understand that the same transactions are being recorded in both methods, it is simply the timing of the posting of the transactions which changes.
Cash vs Accrual Accounting and Revenue
A simple example will serve to show the difference between the two methods. Suppose a business is preparing income statement financial projections, and plans for revenue of 300, 400, and 500 in months 1, 2 and 3 respectively (in months 4 and 5 we will assume for the sake of demonstrating the point, that the revenue is zero, although in reality the projection would continue). If also plans to offer two month credit terms to customers, meaning that the business will receive cash from customers two months after supplying the goods.
Under the cash basis of accounting, the business will show the revenue when the cash is received as follows:
The two months credit offered to customers result is no cash being received in months 1 and 2.
However, under the accrual basis of accounting the revenue is recorded when the the revenue is earned (goods dispatched and invoiced to customers), and the financial projections would be presented as follows
Under both methods, the total revenue for the four months is the same at 1,200, however the timing of the presentation of the revenue in the financial projections changes. Under the cash basis of accounting the revenue is shown when cash is received from the customer (two months later), whereas under the accrual basis of accounting the financial projections shows the revenue in the month it is earned.
Cash vs Accrual Accounting and Costs
To understand why which accounting basis is chosen matters we need to look at the costs used in the financial projections. Suppose in the above example our costs were 120, 160, and 200, and these were incurred with a supplier who gave the business one month credit terms (meaning the business pays the supplier one month after receiving the supplies). If again, we compare the cash vs accrual accounting methods by preparing the financial projections we get the following.
In the cash basis of accounting the financial projections show when the cash is paid to the supplier which, due to the credit terms, is one month after the benefits of those costs have been received by the business.
In the income statement, under the cash basis of accounting, there is no apparent relationship between the revenue received and the costs paid in a particular month.
If we now look at what happens under the accruals basis of accounting, in this case, the costs would be shown in the financial projections in the month in which they were incurred, that is in the month in which the business received the benefit.
Under the accrual basis of accounting the revenue is shown when earned and the costs are shown when the benefit of them is received, this process effectively matches the revenue to the costs necessary to generate the revenue, in accounting terms this is referred to as the ‘matching principle’.
It should be noted that in both cases the total net income for the five months is the same at 720.
The above example showed what happened when revenue and costs are not matched due to the use of credit terms, however, the situation becomes even more distorted when capital equipment or inventory are purchased. Under the cash basis of accounting the full cost of the equipment or the inventory would be included when paid for, whereas under the accrual basis of accounting only a proportion of the cost of the capital equipment relating to its usage (depreciation) would be charged each month, and only the inventory used during the month to produce the goods which are sold, would be charged to the income statement.
Advantages and Disadvantages of Cash vs Accruals
Cash accounting is objective and easier to carry out, cash either comes into the business or goes out of the business. However, the cash method of accounting makes no attempt to match costs to the revenue it generates. The method produces a distorted view of earnings, and does not comply with generally accepted accounting principles, and should not be used to produce financial projections.
The accrual basis of accounting is initially more difficult to understand, but is the preferred method to use for preparing financial projections as it ensures that expenses are matched to revenues and therefore more accurately measures the current earnings of the business. As the accruals basis is in accordance with generally accepted accounting principles, it is the method which investors, and lenders would expect to have been used when they are reviewing financial projections.
Cash vs Accrual Accounting and Financial Projections
Our financial projections template uses the accruals basis of accounting. It does this by using days sales outstanding, and days payable outstanding to allow for the credit terms, and by adjusting for opening and closing inventory using inventory days. In addition, it matches the cost of capital equipment purchased to the revenue it produces by allowing for the depreciation expense over the life of the equipment.
Using these techniques, the financial projections income statement reflects the projected earnings of the business on the accruals basis of accounting and not the cash basis of accounting. As the income statement does not show the cash flow in and out of the business, the financial projections template also includes a cash flow statement to overcome this problem.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.