Cash Basis vs. Accrual Basis Accounting
Understanding the profitability of your real estate is an essential aspect of real property ownership. At a very minimum you should review the financial statements of your real property on a monthly basis. A monthly financial review is enough to ensure you’re building wealth or determining what course of action to take when things are going in the wrong financial direction. The foundation of every financial statement is the method of accounting used to prepare those financial statements. The two most common methods of accounting are the cash basis method and the accrual basis of method.
This article will provide you with a fundamental understanding of the differences between the cash basis method of accounting (cash basis) and the accrual basis method of accounting (accrual basis) and state the pros and cons of using each method as a real estate owner. Armed with this knowledge will give you better insight into the financial position of your real estate holdings. We will mainly focus our discussion on the Income Statement and take a brief look at the Balance Sheet.
What Does Basis of Accounting Mean?
In simple terms, the accounting rules that determine when, and how, you record financial events on your income statement is the basis of accounting. Stated differently, something in life is happening, or has happened, regarding your real estate that results in revenue or an expense. Accounting basis determines when and how much revenue or expense is reported on your income statement.
Let’s use the following examples of real-world events and see how we account for them in the cash basis and accrual basis of accounting. Assume it’s January 1, 20XX.
- You received a $12,000 bill from your insurance company for 12 months of liability insurance coverage.
- Ten days later, on January 11, 20XX you pay the $12,000 premium.
- Your property management company sends an invoice to your tenant for $1,500 for January 20XX rent.
- Your tenant pays the $1,500 invoice 5 days later.
Each of these events may result in an entry on your income statement depending on the basis of accounting used. Let’s start with the Cash Basis.
What is Cash Basis of Accounting?
The Cash Basis of accounting states that an entry is made to your income statement when cash is received, or cash is paid. Don’t take the word cash literally. Cash also means check, credit card, ACH, wire or any form of payment. The receipt of cash results in booking (booking means performing a journal entry that results in a change to your financial statements) revenue to your income statement. The payment of cash results in booking an expense to your income statement.
Pretty simple, isn’t it? Simplicity is one of the positive aspects (pros) of cash basis accounting. Follow the money. If no check, credit card payment or cash is received you recognize no revenue on your income statement. If you don’t cut a check, pay by wire or ACH, no expense is recognized on your income statement.
Let’s use the four examples above to see the Cash Basis Method of accounting in action:
What is the Accrual Basis of Accounting?
The Accrual Basis of accounting ignores when cash is received, or cash is paid, and records revenue when it is earned or an expense when it is incurred. I know I just lost some of you but stick with me.
What does earned mean when it comes to revenue? Earned means that you have completely done, or substantially done, what you promised to cause someone to owe you money.
What does incurred mean when it comes to expenses? Incurred means someone else has done something, or has substantially done something, to cause you to owe someone money.
Let’s apply these definitions to the four examples above to illustrate their meaning:
- You received a $12,000 bill from your insurance company for 12 months of liability insurance coverage. Result: You book $1,000 in each month ($1,000 in January, $1,000 in February, $1,000 in March….$1,000 in December) over the next 12 months. Why? The insurance company has promised to protect your asset for 12 months for $12,000, therefore you record $1,000 for each month that your insurance policy covers. You record $1,000 as a January 20XX expense even though no cash was used to pay for the policy.
- Ten days later you pay the $12,000 insurance bill. Result: No entry on your income statement. Why? Even though you cut a check for $12,000, cash paid has no impact on the accrual basis income statements. The income statement is only changed when the expense is incurred.
- Your tenant is sent an invoice for $1,500 for rent owed to you. Result: You book $1,500 for Rental Income. Why? Your contract calls for payment in advance and you plan to honor that contract therefore you have earned your income and can record revenue on you income statement.
- You receive the rent payment 5 days later. Result: No entry on the accrual basis income statement. Why? Even though you received $1,500, accrual basis income statements ignore cash received and recognize income only when you’ve earned the income.
Another important concept of Accrual Basis accounting is something called the Matching Principle. This principle states that you must match your expenses to your revenue in a given period. In other words, the pro of accrual accounting is that it provides you a true measurement of profitability (revenue minus expenses) in each period where revenue is recognized. Let’s clarify using one month with the above examples.
If the events above all occurred in the Month of January 20XX and they were the only transactions for that month your Income Statements would look as follows:
Wow! What a difference!
Let’s look at February 20XX and assume that we invoiced $1.500 for rent and collected the rent in the same month.
NOTE: Since we already paid the insurance invoice in January 20XX no Insurance Expense is recorded on the Cash Basis. The Accrual Basis shows $1,000 in Insurance Expense each month because your policy covers you for the year and one month is 1/12th of the total $12,000 bill.
By looking at the above Income/(Loss) amounts you can see two “cons” of the Cash Basis method. It’s easily manipulated and can cause wild swings in Income/(Loss). What do I mean by easily manipulated? You can control the magnitude of your profit and loss by simply not paying an expense. If the expense is not paid, it’s not recorded, and your profits go up. Having to pay all those invoices in the future will cause your profits to go down because all those expenses will be jammed into one month. That what I mean by wild monthly swings can result from cash basis accounting.
What is the Difference Between Cash & Accrual Methods of Accounting?
The simple answer is timing.
Let’s take the same scenario and look at 12 months of financials statements using the Cash Basis Method and the Accrual Basis Method.
Several things to observe.
- At the end of 12 months both methods show the same Year-To-Date Income/(Loss), but each month shows a different Income/(Loss). This is what I mean by Timing.
- The Cash Basis Method shows a greater monthly fluctuation in Income/(Loss)
- Conversely, the Accrual Basis Method has a smoother monthly fluctuation (in this case no change at all).
- If you wanted to know how much cash was received or paid in a given month the Accrual Basis Income Statement won’t help you. The Cash Basis shows you exactly how much cash was received and paid out each month. If you’re concerned about tracking cash the Accrual Basis Method is more difficult to use. This is a “con” about the Accrual Method.
The Balance Sheet
The Balance Sheet, also called the Statement of Financial Position is a financial statement that records your Assets (amounts owed to you or things you own), your Liabilities (amounts that you owe), your Equity (the amount of the Assets you own). In a simple example, assume you purchased your first piece of real estate for $100,000. How did you pay for it? You took $20,000 out of your savings account and borrowed $80,000 from the bank. Your Balance Sheet would look as follows:
Note that the reason it’s called a Balance Sheet is because Assets will always equal Liabilities + Equity (A = L+E). Every asset you own is either paid for with your money, someone else’s money, or a combination of the two.
If you decide to use the Accrual Basis of accounting you must also have a Balance Sheet. The Balance Sheet works in conjunction with Accrual Basis Income Statements. The reason for this is that one of the purposes of the Balance Sheet is to “store” cash transactions that are not yet recognized on the Income Statement.
If we go back to our Insurance Expense example, we paid $12,000 in January but we’re only recognizing (recording as an expense) $1,000 in Insurance Expense in January. Where did the other $11,000 go? On your Balance Sheet, in the form of an Asset called Prepaid Insurance. Why as Asset? Because you paid for 12 months of coverage but only booked one month ($12,000 multiplied by 1/12th of a year = $1,000). The other 11 months of coverage is owed to you. If you recall, anything that is owed to you is an Asset.
I don’t want to get too deep in the weeds with the Balance Sheet but the above example should give you a feel for the additional complexity (a “con”) of the Accrual Basis of Accounting.
Note that there is no need for a Balance Sheet for the Cash Basis of Accounting because every dollar of cash received or spent appears on the Income Statement.
In conclusion, if you have a fundamental understanding of both methods of accounting it doesn’t matter what method you use. The only difference between the two is the timing of when transactions hit your Income Statement.
Below is a quick grid of the “pros” and “cons” of each method. If you’re still unsure it’s always best to request the cash basis of accounting since it’s easier to understand, does not require a Balance Sheet and you’ll be able to track your monthly cash inflows and outflows.
