The bottom line on a profit and loss statement can be significantly affected by whether an entity is using the accrual or cash method of accounting. Under the cash method, income and related expenses can easily end up in different periods. As a result, cash basis profit and loss statements generally lack accuracy compared to those prepared under the accrual method.
The profit and loss statement, or income statement, is one of the most important measures of financial condition. The top section of the statement includes the income of the entity for any given period, while the lower portion presents categorized expenses. The difference between the income and expenses is the net profit or loss, which often reveals where a business is really headed.
Not all income statements are created equal, however. The bottom line with regards to profit or loss can be vastly different, depending on whether the income statement was prepared using the cash or accrual method of accounting.
Under the cash method, income is only recorded if the money is actually received. Similarly, expenses are recorded only if cash really left the bank account. In contrast, the accrual method of accounting records income in the period it was earned, and expenses in the period in which they were incurred.
The cash method of accounting, while simple and easy to implement, leaves much to be desired in terms of financial statement accuracy. For example, a building contractor operating on the cash basis might finish a small remodeling project in December. He has incurred all the expenses for the job, the income is actually earned, but the money has not been received. Under the cash basis of accounting, the expenses would be recorded in December but the income wouldn’t be recorded until it comes in. As a result, the builder’s December financial statements would not show his true financial condition.
In contrast, the accrual method of accounting would require that the income be recorded in December, along with accounts receivable. The income and expense would be properly matched, facilitating the presentation of more accurate financial statements.
In recognition of the fact that the accrual method of accounting generally results in more accurate financial statements, the American Institute of Certified Public Accountants requires audited financial statements to be prepared on the accrual basis. The accrual basis is also the method recommended by Generally Accepted Accounting Principles (GAAP), a framework of accounting standards, rules and procedures defined by the professional accounting industry and adopted by nearly all publicly traded U.S. companies. Banks also generally request that financial statements be prepared on the accrual basis when presented with loan applications.
The choice of whether to use the cash or accrual method of accounting also has tax implications. Consider what would happen if the builder mentioned above had been on the cash basis and the customer paid for the job in December. If the builder put the project expenses on his credit card and didn’t pay them in January, he could have the unhappy experience of paying tax on the income without getting to take the offsetting expense. The fact that the expense would be available in the following year wouldn’t help his wallet this year. Thus, the choice of cash vs. accrual for recording profit and loss can have important (and adverse) tax, as well as income statement, implications.
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