Learning Outcomes
After studying this article, you will be able to compare cash and accrual accounting, explain their recognition principles, analyze their impact on financial reporting, and recognize how each method affects the interpretation of company performance for the CFA exam.
CFA Level 1 Syllabus
For CFA Level 1, you are required to understand how accounting methods affect reported financial results and the interpretation of financial statements. In particular, focus your revision on:
- The distinction between cash and accrual accounting methods for recognizing income and expenses
- Implications of each method for reported performance and position
- The effect of recognition timing and measurement on financial analysis
- Comparing limitations and benefits for exam scenarios
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Which accounting method recognizes revenue only when cash is actually received from customers?
- True or false? Accrual accounting recognizes expenses only when cash is paid to suppliers.
- What is one potential weakness of financial statements prepared strictly using the cash accounting method?
- How would switching from cash to accrual accounting affect a fast-growing company's reported profits?
Introduction
A clear understanding of the difference between cash and accrual accounting is fundamental for financial reporting and analysis. The method chosen for revenue and expense recognition can have a significant impact on a company's reported profits, financial position, and comparability across reporting periods. The CFA curriculum requires you to not only identify the mechanics of each approach but also to appreciate their implications for interpreting financial statements and making investment decisions.
Key Term: Cash Accounting
An accounting method that records revenues and expenses only when cash is received or paid, regardless of when the transaction occurs.Key Term: Accrual Accounting
An accounting method that records revenues when earned and expenses when incurred, irrespective of when cash is exchanged.
Cash Accounting
Cash accounting is a straightforward system where transactions are recorded only when cash changes hands. Revenue is recognized when payments are received, and expenses are recorded when cash is paid out. This approach matches closely with cash flows but can provide a misleading picture of profitability and financial position if substantial sales or purchases occur on credit.
Key Term: Revenue Recognition (Cash Basis)
Recognizing revenue only when payment is actually received from the customer.
Accrual Accounting
Accrual accounting, required by IFRS and US GAAP for public companies, recognizes income when it is earned and expenses when obligations are incurred, regardless of the timing of actual cash flows. This method is designed to present a more accurate, period-based view of a company's performance and obligations. It relies on applying specific recognition and matching principles.
Key Term: Revenue Recognition (Accrual Basis)
Recognizing revenue when goods or services are delivered and the earnings process is substantially complete, even if cash has not yet been received.Key Term: Expense Recognition (Matching Principle)
Recording expenses in the period in which the related revenues are earned, not necessarily when cash is paid.
Comparison: Key Mechanics
| Cash Accounting | Accrual Accounting | |
|---|---|---|
| Revenue | When cash is received | When earned (goods/services delivered) |
| Expense | When cash is paid | When incurred (matched to revenue) |
| Timing | Follows cash flows | Follows economic activity (period-based) |
| GAAP/IFRS | Not permitted for public companies | Required for public companies |
Worked Example 1.1
A consulting firm completes a project on 20 December. The client pays on 15 January. When is the revenue recognized under each method?
Answer:
- Under cash accounting: Revenue is recognized in January, when payment is received.
- Under accrual accounting: Revenue is recognized in December, when the work was completed.
Worked Example 1.2
A company buys raw materials worth $50,000 on credit on 28 February and pays the invoice in March. Under each method, when is the expense recorded?
Answer:
- Under cash accounting: Expense is recorded in March, when cash is paid.
- Under accrual accounting: Expense is recorded in February, when the obligation to pay is incurred (assuming materials are used in production in February).
Implications for Financial Analysis
Cash accounting may misstate performance—particularly for businesses with significant receivables or payables—since profits can be "managed" by timing payments. Accrual accounting offers a more accurate measure of performance in each period, but requires greater judgment and introduces estimation risk.
Key Term: Matching Principle
The principle requiring that expenses be recorded in the same period as the revenues they help to generate.Key Term: Period Cut-off
The process ensuring that income and expenditures are recognized in the correct accounting period, as required by accrual accounting.
Cash vs. Accrual—Strengths, Weaknesses, and CFA Relevance
- Cash accounting accurately reflects liquidity and cash flows, making it useful for very small or cash-based businesses and for cash flow analysis.
- Accrual accounting provides relevant information on profitability, financial position, and performance, but requires careful review of estimates (e.g., doubtful debts, accrued expenses).
Exam Warning
Cash-based numbers (like timing of receipts and payments) can deviate significantly from reported accrual-based net income, especially for growing companies or where significant credit terms are offered. For CFA questions, always check whether the figure needed is cash-based or accrual-based.
Revision Tip
If you are given both a cash receipts/payments schedule and invoice-based (accrual) sales/purchases table, pause to note which method the question is really asking about, and double-check the period being used.
Summary Table: Cash vs. Accrual Accounting—Quick Reference
| Feature | Cash Basis | Accrual Basis |
|---|---|---|
| Recognition Timing | Cash changes hands | When earned/incurred |
| Revenues | On cash receipt | On delivery of goods/services |
| Expenses | On cash payment | When obligation incurred |
| Financial Position | Understates payables/receivables | Accurate, includes accruals |
| CFA Focus | Not permitted under GAAP/IFRS for listed companies | Required by standards |
Key Point Checklist
This article has covered the following key knowledge points:
- Explain the difference between cash and accrual accounting
- Identify when revenues and expenses are recognized under each method
- Understand the matching principle and its relevance under accrual accounting
- Recognize the implications of recognition method for performance analysis and exam questions
- List strengths and weaknesses of cash and accrual accounting
Key Terms and Concepts
- Cash Accounting
- Accrual Accounting
- Revenue Recognition (Cash Basis)
- Revenue Recognition (Accrual Basis)
- Expense Recognition (Matching Principle)
- Matching Principle
- Period Cut-off