Accrual vs. cash accounting, explained.
A business that keeps its financial records ("books") on the CASH basis (or method) records revenue when RECEIVED and expenses when PAID. It's simple, and the income statements reflect the true CASH inflow and outflow of the business. The downside is the financials may not truly reflect the value created or lost, at least not when it's created or lost.
For example, let's say Customer A agrees to buy from XYZ a product for $120,000, paid in 12 equal installments over a year. The first payment will be due in 30 days. XYZ will spend $58,000 building and delivering it, and it can do so in 30 days.
Using the Cash method of accounting, XYZ will not record anything upon the signing of the agreement. Assuming XYZ buys its raw materials on terms, the first entry in XYZ's books (directly associated with the subject transaction) will likely be 30 days hence--a revenue entry for receipt of the initial installment payment ($10,000). Expenses associated with the transaction, such as the purchase of steel, labor, power and freight services--will be recorded as they are paid in cash. As such, someone looking at the financial statements of XYZ 55 days from the date of the sale will see one payment of $10,000 and approximately $48,000 of expenses. The transaction, as of this date, shows a $38,000 loss.
ACCRUAL accounting is quite different. It basically ignores when the cash actually goes in and out. Revenue is booked when it's EARNED, and expenses are booked when the liability is INCURRED. Using our example, the business using ACCRUAL accounting would record, on the date of the transaction, $120,000 of revenue and $62,000 of direct expense. As a result, the bottom line would show a $58,000 profit--all on the day the agreement is signed. The logic is that this is what really happened, economically. The business earned the right to receive $120,000, committed to spend $62,000, and earned $58,000 in profit.
Accrual accounting requires more entries than the cash method. The company that uses accrual will ALSO record actual receipt and payments of cash; they just won't impact revenue, expense and income.
The knock on accrual accounting is that it can accelerate income and therefore taxes. The knock on cash accounting is that the financials don't reflect the true financial and economic position of the business.
These examples are simple and attempt to relate only a few of the differences between cash accounting and accrual accounting. An accountant or CPA can explain the details and help you choose and set up the best system for your business.
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|Publication:||The Business Owner|
|Date:||Jul 1, 2011|
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