With accrual accounting, the business matches income and expenses regardless of the timing of cash flow. This creates the need for a series of other balance sheet items to account for timing differences between the recognition of income or expenditure and cash flows. Examples of such accounts are inventory, accounts receivable, and accounts payable.
Another advantage of cash accounting is that it generally defers certain taxes, as it generally recognizes income more slowly and expenses more quickly than accrual accounting systems.
For example, a business starts a $ 25,000 job on December 1 and ends it on December 15. The company pays $ 15,000 for materials and labor used for the job in December. The customer pays on January 20.
With accrual accounting, December will show a profit of $ 10,000 (because the business will recognize both income and expense when the job is done). The business will have to pay taxes on the $ 10,000 in the current year.
On a cash basis, December will show a loss of $ 15,000 (because the expenses, which the business paid in December, are recognized). Current year taxes will be reduced because of the $ 15,000 loss.
However, next year’s taxes will be increased by the $ 25,000 profit that will occur when revenues are recognized in January. If the company’s marginal tax rate remains unchanged, it will pay the same amount of tax, but tax will be deferred if cash accounting is used.