At the risk of losing half of you at the mere mention of accounting, I’m going to do it anyway. Accounting can be confusing, but wrapping your mind around a few key concepts can put you far ahead of your competition.
What is Accrual Accounting?
A lot of the confusion in formal accounting comes from the difference between accrual basis accounting and cash basis accounting. Cash basis accounting is what a ‘normal’ person would consider a rational method of tracking things. Accrual basis accounting is what the accountants use.
Under the accrual basis accounting, revenues are reported on the income statement when they are earned. Under the cash basis accounting, revenues are reported on the income statement when cash is received.
Same goes for expenses:
Accrual basis accounting matches expenses with the related revenues when the expense occurs.
And in cash accouting? You guessed it – expenses are booked when the cash is paid.
What Were They Thinking?
The reasoning behind accrual accounting is that it creates an a more realistic income statement (in terms of profitability) during a specific time period. Of course, cash is always KING, and you’ll die without it. But with the income statement we’re looking at a company’s ability to earn a profit.
Accrual Acconnting and the Income Statement
Accrual vs. cash accounting first hits the income statement. Here’s an example:
I start a cat sitting service in June and provide $1,000 of cat sitting services in June, but I don’t get paid until I bill in July. And let’s just say for argument I go on vacation in July and provide no services. There will be a difference in the income statements for June and July under the accrual and cash bases of accounting.
Under the accrual basis, my income statements will show $1,000 of revenues in June and $0 in July. Under the cash basis, it’s just the opposite because cash basis is concerned with when I receive funds, not when I perform services. My June income statement would show no revenues, and I’d have $1,000 in July.
Accrual Accounting and the Balance Sheet
The balance sheet is also affected. Under accrual basis, the June balance sheet will show accounts receivable of $1,000, but under cash basis the $1,000 of accounts receivable will not be reported as an asset until July. (Actually, under cash accounting you wouldn’t have accounts receivable. You either have the cash, or you don’t.)
To extend the example to expenses assume that I buy cat litter for my kitty sitter service business in bulk. Under accrual basis accounting, I would create an asset for the entire amount of litter when I purchase it and expense it out over time as I perform services. This matches the expense to the revenue. Under cash basis accounting, I would expense the entire amount of litter when I purchased it.
Which Method Should You Use?
It depends. The accrual method must be used to match revenues and expenses for financial statements prepared in accordance with Generally Accepted Accounting Principles (GAAP). However, most small businesses can choose whichever method suits their business (and record keeping!) needs best.