Cash basis vs accrual basis — Accounting Module 11

The single decision that shapes a company's accounting more than any other is whether to run cash basis or accrual basis. Cash is what bank statements show. Accrual is what real economic activity looks like. They diverge in important and informative ways.

The difference, in one example

You sign a 12-month consulting contract worth KES 1,200,000 in January. The client pays KES 600,000 upfront. You deliver services through the year. The remaining KES 600,000 is paid in December.

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CASH BASIS — recognises revenue when cash arrives:
   January: KES 600,000 revenue
   Feb-Nov: KES 0 revenue
   December: KES 600,000 revenue
   Annual total: KES 1,200,000 — but lumpy and misleading

ACCRUAL BASIS — recognises revenue when earned (service delivered):
   January: KES 100,000 revenue (1/12 of contract)
   Feb: KES 100,000
   ...
   December: KES 100,000
   Annual total: KES 1,200,000 — smooth and informative

Balance sheet treatment of the upfront payment in accrual:
   January 1: DR Cash 600,000 / CR Deferred Revenue 600,000 (a liability)
   Each month: DR Deferred Revenue 100,000 / CR Service Revenue 100,000
   Year-end: Deferred Revenue is now KES 0 (fully earned)

Same economic reality, two ways of presenting it. Accrual is what banks, investors, and tax authorities want to see for any business of meaningful size.

When cash basis is honest

Freelancers and one-person consultancies with simple billing.
Cash-paid trades (kiosks, market stalls) where credit isn't extended.
Tax purposes in some jurisdictions for small businesses (Kenya allows cash basis below KRA turnover thresholds; US allows for businesses under ~$25m revenue).
Personal finance — your household budget IS cash basis, and that's correct.

When accrual is mandatory

Publicly listed companies (IFRS and US GAAP both require it).
Companies that extend customer credit or have inventory.
Companies seeking bank loans or external investment of any meaningful size.
Most regulated industries (banking, insurance, pensions).

The cash-basis trap for growing SMEs

Small businesses often start on cash basis because it's simpler. When they grow and add inventory, credit sales, or hire payroll-based staff, cash basis starts to lie about profitability. The classic case: a growing business looks unprofitable on cash basis (cash going out for inventory and salaries; receivables not yet collected) while genuinely making money on accrual. Lenders see the cash-basis books and refuse to extend credit. The fix is to switch — typically with help from an accountant — but it's painful mid-year.

Tax basis vs financial-reporting basis

An interesting wrinkle: tax authorities sometimes allow cash basis where financial reporting requires accrual, or vice versa. A business might keep books on accrual for its bank but on cash for its tax filings — same business, two valid views. The differences are tracked in 'deferred tax' accounts. This is how Apple can have a US tax provision and IFRS profit that differ by billions — different basis rules, both legal.

Exercise

A boutique in Nairobi sells inventory on 30-day credit to its wholesale customers. December was its biggest sales month ever (KES 5m of invoices). January 1, the bank balance is at a normal level — most of December's sales hasn't been collected yet. Inventory is depleted because they sold so much. What does the December P&L look like under cash basis vs accrual? Which gives the truer picture? Why is this distinction important if the owner wants a loan?