Accrual vs Cash Accounting: Differences Explained

Cash basis accounting records a transaction only when cash is exchanged. Accrual basis accounting records revenue when it is earned and an expense when it is incurred, whatever the timing of the cash. That one difference is behind adjusting entries, receivables and payables, prepaid expenses and unearned revenue, which together make unit 4 of a first accounting course the largest in the book. If you understand why the two bases differ, the entries stop feeling arbitrary.

The two principles behind accrual

• Revenue recognition: record revenue in the period in which it is earned, meaning the product or service has been provided. Earning the revenue, not collecting the cash, is the trigger.
• Matching (expense recognition): report an expense in the same period as the revenue it helped earn, even if the bill is paid later.

Under the cash basis, recognition moves to the date cash changes hands, so revenue and expense can land in a different period from the activity that caused them. Accrual statements show what was earned in a period and what it cost to earn it.

One month, two views

Here is a month at Maple Street Consulting, a running example in the course. It pays 6,900 to settle an accounts payable balance for a cost recorded earlier. It bills clients 5,200 for consulting performed this month, unpaid at month end. Separately, it performs 3,700 of consulting that clients pay for in cash right away.

Cash: it moves only on the payment and the collection. -6,900 + 3,700 = -3,200. The billing moves no cash.

Accrual net income: it rises by the 5,200 billed and earned, plus the 3,700 earned and collected. That is +8,900. The 6,900 payment settles a cost already expensed, so it does not change income.

Cash fell while accrual income rose. Neither number is wrong, they answer different questions: how much cash did we have move, and how did we perform in the period?

Why adjusting entries exist

Some events produce no source document. Nothing arrives in the mail to say that supplies were used or that revenue was earned. So at the end of each period, accountants record the effects that are not yet on the books. These adjusting entries are step 5 of the accounting cycle, followed by the adjusted trial balance (step 6) and the financial statements (step 7).

Two rules hold for every adjusting entry:

1. It pairs one balance sheet account with one income statement account.
2. Cash never appears in it. Adjustments deal with timing differences, and cash has already moved or will later.

Deferrals and accruals

The four types fall into two families, defined by which comes first.

• Deferral: cash moves first, recognition comes later. Prepaid expenses and unearned revenue.
• Accrual: recognition comes first, cash comes later. Accrued expenses and accrued revenue.

A quick test: an adjusting entry that includes a payable or a receivable belongs to the accrual family.

Prepaid expenses

A prepaid expense is a cost paid before it is used. It starts as an asset, and the adjusting entry moves the used part to expense. If the Supplies account holds 8,500 before adjustment and a count shows 1,200 on hand, the supplies used are 8,500 - 1,200 = 7,300: Dr. Supplies Expense 7,300 / Cr. Supplies 7,300. For insurance, a 12-month policy paid July 1 for 3,600 costs 3,600 / 12 = 300 a month, so at December 31 the six months that have passed are 1,800 of Insurance Expense.

Unearned revenue

A customer's advance payment for work not yet done is a liability, because the company still owes the service. A customer pays 9,000 in advance: Dr. Cash 9,000 / Cr. Unearned Revenue 9,000, and no revenue yet. When 600 of 4,000 prepaid services has been performed, Dr. Unearned Revenue 600 / Cr. Service Revenue 600, leaving 3,400 as a liability.

Accrued expenses

A cost incurred but not yet paid. Employees earned 1,500 in the last days of the period and will be paid next period: Dr. Salaries Expense 1,500 / Cr. Salaries Payable 1,500. When the cash is paid, Dr. Salaries Payable / Cr. Cash, with no new expense for the accrued part. Interest uses principal x annual rate x months / 12: a 12,000 note at 10% for 2 months accrues 12,000 x 0.10 x 2/12 = 200.

Accrued revenue

Revenue earned but not yet recorded or collected. A 24,000 note receivable at 6% has earned 24,000 x 0.06 x 4/12 = 480 of interest after 4 months: Dr. Interest Receivable 480 / Cr. Interest Revenue 480. When the cash arrives later, the receivable is cleared and no new revenue is recorded for the accrued part.

What happens if you skip the adjustment

This table is easy to rebuild from first principles: ask which account was left out, then which way that skews net income.

Reporting periods

A fiscal year is any 12 months and can begin in any month, such as April 1. A calendar year runs January 1 to December 31. Any period shorter than a year, such as a month or quarter, is an interim period. Adjusting entries are made at the end of each period.

Common mistakes

• Putting Cash in an adjusting entry. It never belongs there.
• Calling a prepaid expense an expense on the day it is paid. It starts as an asset.
• Treating an advance payment as revenue. It is a liability until the work is done.
• Forgetting that paying an accrued expense later does not create a new expense.
• Counting what is left in the supplies count as the amount used. The count gives what remains.

Practicing it

The skill is classification: given a situation, decide deferral or accrual, then which accounts. Say your classification aloud before writing the entry, which is active recall applied to a problem. Then rebuild the four-row table above from memory, since the forgetting curve will take most of it within days without review.

Unit 4 follows debits and credits explained, which covers the entry mechanics used above. What's in Financial Accounting maps all 16 units, and how to study for financial accounting covers the order. The depreciation adjusting entry is its own case, built out in depreciation methods compared with the depreciation calculator. Every example here comes from the free Financial Accounting course.