Introduction.
Accounting sometimes can be compared to law – there are some basic rules every Accountant has to follow so that their work is interpreted correctly. On of the most important of them, is so called ‘Matching Principle’ – which is the base for the Accrual Accounting. Today we will talk about what it exactly means and we will describe two main approaches in Accounting.
Cash-flow Accounting vs. Accruals Accounting.
Basically, mentioned above are the two main approaches that can be undertaken in Accounting. Cash-flow Accounting is very simple – transactions are recorded when cash is paid or received. However, one of the key financial statements – the Income Statement (about which an article will be published soon), is prepared on the basis of Accruals Accounting. Accruals accounting reports revenues or expenses in the period to which they relate to, no matter whether cash has been received/paid or not.
How do Accruals Accounting and Cash-Flow Accounting work?
Let’s analyse an example to see how these two approaches work in practice.
Example.
‘ABC Computers’ is a company, which manufactures professional computers for IT Specialists. On 17 December 2020, Mr Alex Goodwin ordered a computer worth £5,500 for his company. The computer has been delivered and accepted by Mr Goodwin on 19 December 2020, but the payment was due 20 January 2021. Mr Goodwin paid the full amount on 2nd January 2021. Company ‘ABC Computers’ has the Accounting Period of ONE year, and the 2020 period ended on 31 December 2020. The next period started on 1st January 2021. How will this transaction be recorded under Cash-flow and Accruals Accounting?
Cash-flow Accounting will record the transaction when the ABC Computers company receives the money from Mr Goodwin. Here, cash will be received on 2nd January 2021. Thus, this transaction will be recorded, under the Cash-flow Accounting, on the 2nd January 2021. Why? Because cash is received on that day.
The situation will be different when we record transactions under Accruals Accounting. Since Accrual Accounting records transactions when goods are accepted by customers or when services are provided to the customer no matter whether cash has been paid or received, we will treat the computer purchase from the example differently. Mr Goodwin received and accepted the computer on 19th December 2020. He has paid the money for the purchased computer on 2nd January 2021. However, under Accruals Accounting, ABC Accounting will record this transaction as revenue earned on 19th December, in the 2020 Accounting Year even though it is going to receive the money later. This is the rule of Accruals Accounting, which matches revenues earned and expenses incurred to the period where they actually occur, not to the period when cash is paid or received.
Overall, two most important financial statements – Balance Sheet and Income Statement are usually prepared under Accruals Accounting basis. International Accounting Standards also require companies to prepare Statement of Cash Flows to show how cash flows look like in a particular company. Statement of Cash Flows analyses what amounts of cash and when were received or paid by the company. This Statement uses Cash-flow Accounting and it to some extent assists Balance Sheet and Income Statement. They altogether can be used to analyse a company’s performance to a greater detail.
Summary.
There are two main approaches to recording transactions in Accounting – Accruals Accounting and Cash-flow Accounting.
Accruals Accounting records revenues earned and expenses incurred in periods in which they actually occur, no matter whether cash has been paid/received or not.
Cash-flow Accounting records transactions when cash has been paid/received (i.e. when cash flow occurs).
Both approaches are used in Accountancy to prepare various statements – when we combine them, using those statements, we can obtain a broader and detailed picture of a company.
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