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Financial Management: Cash Vs. Accrual Accounting Danny Klinefelter, Dean Mccorkle and Steven Klose*

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Financial Management: Cash Vs. Accrual Accounting Danny Klinefelter, Dean Mccorkle and Steven Klose* EAG- 036 February 2017 Risk Management Series Financial Management: Cash vs. Accrual Accounting Danny Klinefelter, Dean McCorkle and Steven Klose* Selecting a record-keeping system is an A business can be going broke and still generate important decision for agricultural producers. a positive cash basis income for several years The system should help with decision making in a by building accounts payable (accruing but not risky environment and calculate taxable income. paying expenses), selling assets, and not replacing Most producers keep their records with the cash capital assets as they wear out. receipts and disbursements method or with an However, most farmers and ranchers use accrual method. cash basis accounting because: 1) the accounting Either method should be acceptable for principles of an accrual system can be complex; calculating taxable income (except for corporate 2) given the cost of hiring accountants to keep taxpayers who have revenues exceeding their records, accrual accounting is more $25,000,000). However, it is not acceptable to keep expensive; and 3) cash basis accounting is more books throughout the year using one method flexible for tax planning. of accounting and then convert at year-end to another method, solely because the second Getting the Best of Both Systems method might compute taxable income more There is a process by which cash basis income favorably. and expense data can be adjusted to approximate The main difference between accrual basis and accrual income. This can be very beneficial to cash basis accounting is the time at which income producers, giving them the simplicity and tax and expenses are recognized and recorded. The flexibility of using cash accounting and the ability cash basis method generally recognizes income to evaluate profit more accurately. The process when cash is received and expenses when cash has been recommended by the Farm Financial is paid. The accrual method recognizes income Standards Council (FFSC), which is made up when it is earned (the creation of assets such as of farm financial experts from across the U.S. accounts receivable) and expenses when they The only requirements for using this process are incurred (the creation of liabilities such as are accurate records of cash receipts and cash accounts payable). disbursements for the period being analyzed, and Accrual accounting is more accurate in terms complete balance sheets (including accrual items) of net income because it matches income with the as of the beginning and end of the period. expenses incurred to produce it. It is also more The process yields an “accrual adjusted” realistic for measuring business performance. income statement. It differs from accrual income *Professor and Extension Economist, Extension Program Specialist–Economic Accountability, and Assistant Professor and Extension Specialist–Risk Management, The Texas A&M System. in that inventories may be valued at their current Note 1: Because depreciation is a noncash expense, market value rather than their cost, and work in technically it would not be reflected on a cash basis process (e.g., growing crops) is valued by direct income statement. Instead, the statement would show the cash payments for property, facilities and equipment costs only (not including indirect labor and rather than allocating the cost of the asset over its useful allocated overhead). life. However, because the Internal Revenue Code requires The process for adjusting cash basis income to capital assets to be depreciated, even for cash basis approximate accrual income is outlined in Table taxpayers, the common practice is to record depreciation 1. “Beginning” and “Ending” refer to information expense for both cash basis and accrual basis income from the balance sheets as of the beginning and accounting. Note 2: It is possible to have an income tax and Social end of the accounting period. Security tax receivable (refund due) or a deferred tax asset. In these instances the sign (+/-) of the period would Table 1. Adjusting cash basis records to approximate be reversed when making the accrual adjustments. accrual basis records. In order to track the logic behind the cash-to- Cash basis Adjustments to Equals accrual adjustment process, consider the following cash basis accrual basis example of a cash-to-accrual adjustment on grain Cash receipts – Beginning inventories Gross Revenue sales. + Ending inventories – Beginning accounts receivable Table 2. + Ending accounts Cash receipts from grain sales this year $150,000 receivable less: Beginning grain inventory – $40,000 Cash disbursements – Beginning accounts Operating (produced in prior year) payable expenses + Ending accounts plus: Ending grain inventory + $28,000 payable (current year production) – Beginning accrued equals: Accrual grain revenue $138,000 expenses (approximate value of current year production) + Ending accrued expenses + Beginning prepaid Consider a second example of an expense expenses adjustment for accrued interest. – Ending prepaid expenses + Beginning supplies (fuel, Table 3. chemical, etc.) Cash disbursements for interest paid this year $36,000 – Ending supplies + Beginning investment in less: Beginning accrued interest – $9,000 growing crops (interest owed but not paid in prior year) – Ending investment in plus: Ending accrued interest + $7,000 growing crops (interest owed but not paid in current year) Depreciation No adjustments made Depreciation equals: Accrual interest expense (approximate cost of $34,000 expense (see Note 1) expense borrowed funds in current year) Cash net income Accrual adjusted (pre-tax) net income (pre-tax) The same logic applies to the cash-to-accrual Cash income and – Beginning income taxes adjustment for other accrual items. The rule to Social Security (S.S.) and S.S. taxes payable remember when making the adjustment is that an taxes + Ending income taxes increase (beginning to ending) in an and S.S. taxes payable – Beginning current accrual-type asset item will cause net income to portion of deferred increase, while an increase in an accrual-type tax liability + Ending current portion liability item will cause net income to decrease. of deferred tax liability Review the example income statements for Cash (see Note 2) Grain Farms (Table 4) to see the differences between Cash net income Accrual adjusted (after-tax) net income statements based on accrual-adjusted information (after-tax) and statements based on cash accounting. 2 Comparing Cash Basis to accrued and deferred income taxes, the expense Accrual-Adjusted Basis for income taxes is increased by $16,000 (from $8,000 to $24,000). Cash Grain Farms (Table 4) appears to be After making the accrual adjustments to the moderately profitable on a cash basis. However, income statement, Cash Grain Farms was shown after adjusting the cash basis income statement to to be more profitable than had been portrayed by approximate an accrual basis income statement the cash basis method of accounting. The more for the same period, net income after tax critical situation would occur if the increased from $18,000 to $46,000. Because of accrual-adjusted net income showed the business the accrual adjustments, gross revenues were to be less profitable than the producer may have greater by $25,000 (from $175,000 to $200,000), been led to believe by relying solely on cash basis while total expenses were less by $19,000 (from income statements. $149,000 to $130,000). However, because of the Cash Grain Farms (cash) Cash Grain Farms (accrual) Year ending December 31 Year ending December 31 Receipts Revenues Cash grain sales $150,000 Cash receipts from grain sales $150,000 Government program payments $25,000 Change in grain inventory + $20,000 Total cash receipts $175,000 Government program payments $25,000 Change in accounts receivable + $5,000 Gross revenues $200,000 Expenses Expenses Cash operating expenses $85,000 Cash distribution for operating expenses $85,000 Interest paid $37,000 Change in accounts payable – $12,000 Total cash expenses $122,000 Change in prepaid expenses + $1,000 Depreciation $27,000 Change in unused supplies – $2,000 Total expenses $149,000 Change in investments in growing crops – $4,000 Depreciation – $27,000 Total operating expenses $95,000 Net farm income from operations (cash basis) $26,000 Interest paid $37,000 Gain/loss on sale of farm capital assets $0 Change in accrued interest – $2,000 Net farm income, before tax (cash basis) $26,000 Accrual interest expense $35,000 Income taxes and S.S. taxes paid $8,000 Total expenses $130,000 Net farm income, after tax (cash basis) $18,000 Net farm income from operations $70,000 Gain/loss on sale of farm capital assets $0 Net farm income $70,000 Income taxes and S.S. taxes paid $8,000 Change in income taxes and S.S. taxes payable Changes in current portion of deferred taxes + $3,000 Accrual income taxes and S.S. taxes Net farm income, after tax (accrual basis) + $13,000 $24,000 $46,000 Remember, because the IRS requires capital assets (machinery, equipment, buildings, etc.) to be depreciated over the useful life of the assets, the common practice, even with cash basis accounting, is to record a depreciation charge. Therefore, there is no difference in the way depreciation is handled between cash and accrual accounting systems. 3 As this illustration shows, computing income Table 6. on a cash basis can misrepresent true profitability Cash Grain Farms for an accounting period when there is a time lag January 1 to December 31 between the exchange of goods and services
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