The two accounting methods

Warren Buffett has called accounting “the language of business.” If you want to invest like he does, you must learn the nuances of accounting.

There's no better way to start than by understanding the two primary accounting methods: accrual and cash accounting.

Accrual accounting and cash accounting methods are both useful in their own ways. This is why investors need both the income and the cash flow statements to get a company’s complete financial picture.

The primary difference between cash and accrual accounting is when revenue and expenses are recognized.

What is accrual accounting?

Accrual accounting anticipates financial events and transactions, while cash accounting records them as they occur (e.g., when the cash actually leaves the customer and is received by the business).

Accrual accounting follows the matching principle, ensuring that revenue and related expenses are recorded in the same accounting period to represent a business’s profitability accurately.

What is cash accounting?

Cash accounting does not follow the matching principle, meaning that revenue and expenses might not be matched to the period in which they were incurred or earned.

Many small businesses will only use cash accounting because it is simpler (bookkeeping only requires that cash movement be recorded) and accurately reflects a company’s cash position.

Real-life example

Investors in public companies must be well-versed in both. The income statement and balance sheet use accrual accounting, while the cash flow statement uses cash accounting.

The difference between these two types of accounting is probably best illustrated using the example of a new car purchase.

Let’s say I use my savings to buy a new car for $33,000. I then drove this car for ten years, at the end of which I sold it for $3,000.

The cash flow statement shows what happened: $33,000 left my account this year, but there is no further impact until I sell it for $3,000.

Using accrual accounting, the income statement smooths out (depreciates) that impact over the time we owned the car. So, the income statement shows an annual net negative result of $3,000 for ten years.

That’s why the cash flow statement doesn't include $3,000 depreciation per year, as it is not annually withdrawn from my account in the ten years following my vehicle purchase.

Key Takeaway

Hopefully, this example helps explain why both the accrual and cash accounting methods are needed.

Accrual accounting better shows a company’s long-term performance and the comprehensive financial health of the reporting company.

Whereas cash accounting is essential for day-to-day operations and cash flow management.

Furthermore, both can be required for tax and financial reporting purposes.

The choice between these methods depends on the business's specific needs, its industry, regulatory requirements, and use cases. Utilizing both methods enables companies to meet various reporting obligations and make decisions effectively.

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