The Battle of Accounting Methods
TGIFF! Finance Friday is back again. Today we are going to look at a really important concept, Cash Accounting verse Accrual Based Accounting. This is something you will need to understand from the start of your business. You should work with your accountant to understand how you should set your books up. Today we will go over the basics of the two types of accounting methods.
What is it?
Cash accounting is a very basic way of accounting for your business. As cash comes into your business from sales, you record the revenue. When the cash leaves your company, you record the expense. The determining factor for revenue and expense recognition is when cash is coming into or leaving your company.
In contrast, Accrual Based Accounting doesn’t care at all when cash is received or sent out. Instead, Accrual Based Accounting is concerned with when did you earn the revenue and when the expenses were incurred. Instead of relying on cash collection, you will need to understand when your earned/incurred revenue and expense and create journal entries to ensure the correct revenue and expense is recorded for the period.
Why does it make a difference?
Let’s say your business is receiving payment for $12,000 from a client in January. This $12,000 is for a service you will be providing to them over the course of the year.
If you record under Cash method in January, you will have 12K of revenue from this client. In every other month, you will have zero dollars of revenue from this client.
Now if you follow accrual accounting, you will still receive the cash in January for $12,000, but at the end of the month, you will defer $11,000 to an account called unearned revenue. This will leave January with revenue of $1,000 which reflects the amount of service you have provided, and therefore the amount of revenue you have earned. Going forward each month you will then enter a journal entry to reflect $1,000 of revenue.
The same will hold true on the expense side. Let’s say in January you pay $1,200 for your yearly insurance premium. If you follow cash basis, you will have an expense for the full $1,200 in January. The rest of the year you will have zero insurance expense. Under Accrual Basis Accounting you will defer $1,100 of the cost, leaving only $100 of expense for January. Then each month you will create another journal entry so that you have $100 of insurance expense hitting.
Accrual Accounting puts the revenue and expense where you have actually earned it/incurred it. This will give you business a more accurate view of how your business is actually performing on a month to month basis. To implement this system you or your bookkeeper will need to create monthly journal entries to adjust revenue/cost and the corresponding asset or liability accounts. You will need to stay on top tracking and ensuring recognition is correct. For some small companies, the effort needed to maintain accrual accounting may not be worth it.
Before deciding work with your accountant to decide what the best strategy is for your business. This is especially true when it comes to taxes as there are some laws that will impact how you report.
See You Next Week!
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