19.1 - Cash vs accrual accounting
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19.1 - Cash vs accrual accounting
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19.1 - Cash vs accrual accounting
- 2. © Michael Allison, Trinity Grammar School. Author’s permission required for external use Profit can be determined with either: Cash Accounting: measures profit by determining whether cash has been received or paid. No cash changing hands means no Revenue or Expense. Accrual Accounting: measures profit by determining whether the business has earned Revenue or incurred an Expense. Whether cash has changed hands is irrelevant. Accrual accounting is the preferred method for most businesses as it is a more accurate measure of Net Profit. Why? Profit in Cash Accounting = Revenue Received -- Expenses Paid Profit in Accrual Accounting = Revenue Earned -- Expenses Incurred 19.1 CASH VS. ACCRUAL ACCOUNTING
- 3. © Michael Allison, Trinity Grammar School. Author’s permission required for external use Many transactions overlap reporting periods, e.g. a firm’s reporting period runs for 6 months from 1 January to 30 June. On 1 April the firm pays $1,200 (plus GST) for insurance for the next 12 months 30 June Profit calculated for 6 months here J F M A M J J A S O N D 1 April Paid $1200 for 12 months insurance Cash Accounting Expense = Expenses Paid Accrual Accounting Expense = Expenses Incurred$1200 $300 1200100 14.1 CASH VS. ACCRUAL ACCOUNTING 100 100 Reporting Period $1,200 / 12 = $100 per month
- 4. © Michael Allison, Trinity Grammar School. Author’s permission required for external use E.g. During March a business had credit sales of $2,000 – the debtor won’t pay for another 6 weeks. In addition, a debtor from February repaid $600. Cash Accounting Revenue = Revenue Received Accrual Accounting Revenue = Revenue Earned$600 $2000 14.1 CASH VS. ACCRUAL ACCOUNTING February March February Credit Sale $600 Collected in… March Credit Sale $2,000 Collected in… Reporting Period
- 5. © Michael Allison, Trinity Grammar School. Author’s permission required for external use E.g. Depreciation on the firm’s vehicle for November was $250 November Cash Accounting Expense = Expenses Paid Accrual Accounting Expense = Expenses Incurred $0 $250 14.1 CASH VS. ACCRUAL ACCOUNTING Reporting Period
- 6. © Michael Allison, Trinity Grammar School. Author’s permission required for external use Transaction Cash Accounting Accrual Accounting Cash sales Credit sales Cost of sales Expenses paid for in cash Expenses incurred on credit Receipts from debtors Payments to creditors Capital contributions of cash Drawings of cash 14.1 CASH VS. ACCRUAL ACCOUNTING
- 7. © Michael Allison, Trinity Grammar School. Author’s permission required for external use Transaction Cash Accounting Accrual Accounting GST collected/paid Depreciation Discounts revenue/Discount expense Interest revenue/Interest expense Money borrowed from a bank (loans) Loan repayments Asset purchases for cash Stock gain/loss 14.1 CASH VS. ACCRUAL ACCOUNTING
- 8. © Michael Allison, Trinity Grammar School. Author’s permission required for external use The theory underlying the use of accrual accounting… Going Concern Principle • The life of the business is assumed to go on forever and exist infinitely • This allows the business to allocate items to future periods rather than allocating them all to the current period • E.g. a firm purchased a $20,000 car that will be used for 4 years with a $0 residual value Year 1 Cash Accounting Expense = Expenses Paid Accrual Accounting Expense = Expenses Incurred $20,000 $5,000 19.1 CASH VS. ACCRUAL ACCOUNTING
- 9. © Michael Allison, Trinity Grammar School. Author’s permission required for external use The theory underlying the use of accrual accounting… Reporting Period Principle • The life of the business is broken into periods of equal length • At the end of each period profit is determined by matching revenues against expenses • E.g. On 1 April the firm prepaid 12 months of insurance for a total of $1,200 April Cash Accounting Expense = Expenses Paid Accrual Accounting Expense = Expenses Incurred $1,200 $100 19.1 CASH VS. ACCRUAL ACCOUNTING
- 10. © Michael Allison, Trinity Grammar School. Author’s permission required for external use The theory underlying the use of accrual accounting… Relevance • Information which influences decision-making must be included in the financial reports • To make effective decisions, a business must be able to calculate profit accurately each period • E.g. during April the firm recorded credit sales of $7,000 which have not yet been collected April Cash Accounting Revenue = Revenue Received Accrual Accounting Revenue = Revenue Earned $0 $7,000 19.1 CASH VS. ACCRUAL ACCOUNTING