Easy

What is the difference between cash and accrual accounting?

How to answer it in an investment banking interview: what is being tested, a step-by-step framework, a sample answer and the mistakes to avoid.

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What the interviewer is testing

Whether you understand the basic recognition principle behind the income statement and can connect it to why cash flow and net income differ.

Answer framework

  1. Cash accounting: record revenue when cash is received and expenses when cash is paid.
  2. Accrual accounting: record revenue when it is earned and expenses when they are incurred, matched to the period they relate to.
  3. Public companies report under accrual accounting (US GAAP or IFRS); cash accounting is mostly for very small businesses.
  4. Give an example: a sale on credit creates revenue and accounts receivable, but no cash yet.
  5. Link to the statements: because net income is on an accrual basis, the cash flow statement reconciles it to actual cash.

Sample answer

Under cash accounting, you record revenue when the customer pays you and expenses when you pay a supplier. Under accrual accounting, you record revenue when you have earned it, meaning you delivered the product or service, and you record expenses in the period they help generate revenue, even if no cash has moved yet.

For example, if a company delivers $100 of services in December and the client pays in February, accrual accounting shows $100 of December revenue and a $100 accounts receivable on the balance sheet. Cash accounting would show nothing until February. Likewise, wages earned by employees in December but paid in January are a December expense with an accrued liability under accrual accounting.

Public companies use accrual accounting under US GAAP or IFRS because it matches revenue and costs to the right period. The trade-off is that net income no longer equals cash generated, which is exactly why we need the cash flow statement: it begins from net income, then reverses non-cash charges and reflects working capital movements to arrive at actual cash.

Likely follow-ups

Can a profitable company run out of cash? Yes. Under accrual accounting it can book profits while cash is tied up in receivables, inventory or capex, so it can still miss payments.

Common mistakes

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Related questions

Based on question #4 in the full question bank.