One of the first decisions a new business must make is whether to adopt cash accounting or accrual accounting. The decision has many ramifications, and most small businesses choose the cash method due to its simplicity. As a company grows and becomes more sophisticated, it will typically migrate to accrual accounting, which gives a better picture of the business’ economic condition.
In the cash method of accounting, you recognize expenses when you disburse money and income when you collect money. In other words, your records are based on actual cash flows. You aren’t concerned with booking expenses and revenue in advance, a time-saving feature of the cash method. This makes it easy to know your cash position at any time. It can also have a tax advantage: you might be able to book expenses in the current year by paying them before January 1, but delay collecting payment for a job until January 1 or later, thereby postponing the tax on the income but benefiting from the deduction on the expense in the current year.
However, cash accounting does suffer from certain disadvantages. One of the biggest downsides of the cash method is that it doesn’t match revenues with the costs required to create those revenues — a concept called the matching principle. This lack of matching makes it difficult to know whether the money you spend is efficiently resulting in a profit. For example, if you spend $100 in June on ink for a printing job, finish the job right away but don’t receive payment until September, there isn’t an easy way to figure the profit from the job, since the ink expenditure was from a different time period.
Another drawback of the cash method is the lack of timeliness. For example, if you complete a job in February but don’t receive payment until June, your cash-method records make it seem like you earned the revenue in June, not February. This, makes it a challenge to connect revenues with the work you performed and when you performed it. In this case, it might seem like you sustained a loss between February and June, while in actuality you had an unbooked profit.
The accrual method recognizes expenses when incurred (rather than paid) and revenue when earned (rather than collected), notwithstanding the timing of the cash flows. Under the accrual method, you are booking transactions as they occur, even though you might not receive or make payments at the same time. Accrual accounting accords with generally accepted accounting principles (GAAP), including the matching principle. Accrual accounting requires work you would skip under the cash method:
- Pre-paid expenses: these are expenses you pay out in advance, such as paying for one year of liability insurance up front rather than in monthly installments.
- Unearned revenue: this is revenue you receive in anticipation of product or service you are obligated to provide in the future, such as when you collect in advance for yearly magazine subscriptions.
- Accrued expenses: these are expenses that you pay some time after incurring them, usually through a payable — wages payable, accounts payable, taxes payable, etc.
- Accrued revenue: these are earnings you book before getting paid, usually through a receivable like accounts receivable, interest receivable, etc.
- Depreciation: this is a non-cash expense resulting from deducting the cost of long-term assets, such as equipment, factories, etc., in annual installments rather than all at once when acquired.
Under accrual accounting, you track all of the revenues and expenses earned/incurred in the period so that you can report profit and loss for the period on the income statement. But you must take extra accounting steps to manage your cash flows, because they are not directly reported in the income statement.
Accrual accounting is more complex but also more accurate, because it satisfies the matching principle plus these principles:
- Revenue recognition: You recognize revenue as soon as a product is sold or a service is performed.
- Cost: The historical amount spent on an item remains the same over time, regardless of any later changes to its value. Net value can change, due to events such damage or depreciation, but these are recorded as separate entries.
- Time period: Every transaction is assigned to an established time period. Financial statements always indicate the as-of date or date range for the information reported.
- Economic entity: Your personal transactions must be maintained separately from those of your company.
- Full disclosure: You must report all significant business activity via the standard financial statements or footnotes.
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