One of the biggest puns in the accounting and bookkeeping world is to say “It’s Accrual World”. To an outsider, one might think that I have fallen off my rocker and lost all sense of my grammar skills. I can promise you that’s not the case. No, I’m not hooked on phonics, and no I have not lost my marbles (ok ... maybe one or two).
In Accounting, there are 2 proper methods of recording transactions in the books for your business; 1) The Cash Basis method of Accounting and 2) The Accrual method of Accounting (this is where the pun comes from). It is important to know because it can and will drastically affect the financial reporting of your business to stakeholders, investors, and the government. When you set up your business and began using your accounting software, you probably made a choice between Accrual or Cash-based accounting in the settings section. If you had an accountant help you set up your software, they probably recommended you use the Accrual Basis of accounting and not the cash basis. I also would also suggest to you that you use the Accrual Basis as well and here's why;
The Accrual method of accounting gauges the financial performance and position of your business by recognizing transactions regardless of when cash transactions occur.
Why is this important? Let’s say you own and operate a health coaching business. On the 29th of September, you perform 1 hour of coaching services at $100 per hour and send your client a bill in the mail for your services. Under the Accrual method of accounting, when you perform the services or provide your products, you earn the revenue associated regardless if you’ve been paid in cash or not. Your customer pays you a few days later on the 3rd of October. Under the accrual basis of accounting, you would recognize Revenue on the 29th for $100 and offset that with an increase in Accounts Receivable for $100 (the bill you sent out on the 29th). On the 3rd of October, you would reduce your Accounts Receivable by $100 (because your customer paid the bill) and increase Cash by $100.
As you can see in the above example, we record 2 activities; the first is when we recognize revenue, the other is when we are paid in cash for our services.
The Cash Basis of Accounting only recognizes revenue and expense when you, the business owner physically receive cash or pay cash out.
Let’s take a look at the same example that we used above. Under the cash method, we only recognize transactions once we receive physical cash. As you can see this will have a drastic change in your business’s financial reporting.
Again, we performed services on the 29th of September but because we are using the Cash basis of accounting, we can’t record any financial activity until your customer pays on the 3rd of October.
Assuming that this was the only service you rendered the entire month, you could easily see how this would affect your financial reporting. In the Accrual method of accounting we earned $100 of Revenue in September but under the Cash basis, we earned $0 in Revenue in September.
Neither method is right or wrong because they are both accepted in the Accounting / Bookkeeping industry. However, it is easy to see how someone could attempt to use the Cash basis of Accounting to their advantage for tax purposes. Because the Accrual basis records all transactions regardless if cash has been received or not, you get a much clearer picture of your business's finances than if you were using the Cash Basis of Accounting.
What does your business use? Cash or Accrual?