The two primary accounting methods used to produce financial records generate materially distinct reports for your small business. This is because the two methods have numerous differences, including the requirements to use them. Although both can be used and are accepted by external users, you may find that your small business benefits from one more than the other.
Cash Method of Accounting
The cash method of accounting is a simplified system that records transactions based on when the cash element of the deal has been performed. In a sale, this is when cash is collected, meaning when you pay the bill – not when you received it. For example, imagine you receive your telephone expense invoice on January 25. Payment is due February 15, and you make the payment on February 15. Because the cash transaction portion – your payment – occurred in February, the telephone expense is recorded in February.
Accrual Method of Accounting
The accrual method records your company’s transactions when the underlying transaction occurs. It disregards when you make the payment and includes the event in the financial statements based on revenue and expense recognition rules. Using the example above, your telephone expense occurred in January because the telephone was used in January. Even if you pay the invoice three months late, the charges are related to usage in a specific month, so that’s where the accrual method entry places the transaction.
Accruals and Deferrals
The main difference between these two methods is accruals and deferrals. These two types of adjusting entries occur in an accrual system and don’t occur in a cash accounting system. An accrual reports a transaction before you collect or pay the cash. The telephone expense example above is an accrual entry. This is because your expense occurred but you didn’t make an immediate payment. The adjusting entry places a liability on the balance sheet to demonstrate the amount of the bill that you owe.
Alternatively, a deferral adjustment occurs after the cash portion of the transaction has occurred, but the underlying benefit is not yet completed.
For example, imagine purchasing $100 of printer paper classified as an office expense. In a cash accounting system, the $100 expense is recognized when you buy the paper. In an accrual method system, the $100 is recorded as an asset on the balance sheet (called supplies). As the supplies are used, an expense is recorded. Therefore, if $10 of printer paper is used each month, a $10 supply expense is adjusted, and it takes 10 months to account for the entire expense.
Both methods have restrictions, and larger public companies are required to use the accrual method of accounting. The accrual method is more difficult, timely, and expensive to incorporate into your records. While the cash method is easier, it provides potentially misleading financial statements.
An example occurs with the supply expense above when the $100 of printer paper was purchased but not used, so the information isn’t a complete picture of your company’s finances. Because the cash method fails to record payables or receivables, it becomes more difficult to forecast future cash flows from operations with this method.
The cash method vs. accrual method shows you the pros and cons of each system. It’s up to you to decide which method works best for your small business. Tracking your financial records helps your business see its viability and growth potential. 4.3 million customers use QuickBooks. Join them today to help your business thrive for free.