Cash Accounting vs Accrual Accounting

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

You are probably familiar with how to read the income statement, balance sheet, and cash flow statement that companies release quarterly (if not, brush up on those topics first).

Let’s learn about the different accounting methods these statements use to understand how the three should be looked at together to gain a holistic picture of a company’s financial health.

The accrual accounting and cash accounting methods are both practical in their own ways. They are 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.

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.

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 (the bookkeeping only requires that cash movement is recorded) and accurately reflects a company’s cash position.

However, 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 buy a new car for $33,000 using savings. I then drive this car for ten years, at the end of which I sell 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 that impact out over the ten years, showing an annual net negative result of $3,000 for ten years.

That’s why the cash flow statement begins with the net income and proceeds to add back the cash that flowed in (e.g., the year I sold my vehicle for $3,000) or money that did not flow out (e.g., $3,000 was not annually withdrawn from my account in the ten years following my vehicle purchase).

Hopefully, this example shows 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.

However, 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 specific needs of the business, its industry, regulatory requirements, and use cases. Utilizing both methods enables companies to meet various reporting obligations and make decisions effectively.

Here’s an infographic that showcases the differences between these two accounting methods: