Cash vs. Accrual Accounting
Companies produce two types of statements: GAAP (Generally Accepted Accounting Principles) and Tax financial statements.
When you read publicly-filed financial statements, they are all prepared under U.S. GAAP standards. Under GAAP, companies must report financial statements using accrual-based accounting methods. However, companies report their financials on a cash basis for tax purposes.
Accrual accounting records revenues and expenses as they are earned. Cash accounting records revenues and expenses as cash moves in and out of the business.
ABC Company sells 100 units of widgets for $20 per unit to a key customer. The cost to make each unit was $10 per unit. Per the sales agreement, the customer agrees to pay in 30 days.
What is the effect on the income statement and balance sheet?
However, because the customer hasn’t paid yet, cash did not actually flow into the firm. Thus, the customer’s cash-based statements would not record revenue until the cash was actually received from the customer.
When the customer finally pays in full, the transaction is recorded as revenue on the cash-based statements. On the accrual statements, the accounts receivable balance for the customer is eliminated and offset by an increase in the cash balance. Companies typically use cash-based accounting for tax statements.