One of the questions a business owner will need to answer is if to keep his/her books using cash or accrual accounting. Before I talk about cash and accrual accounting you should understand the difference between accounting events and accounting transactions.

Accounting events

An event is a transaction that changes a business financial statement. An event causes a change in either the assets, liabilities or equity section of the balance sheet. An example of an event is selling a good or service on credit. An event does not have to immediately exchange value.

Accounting Transactions

An accounting transaction is an event that involves the transfer of value between two parties. An example of a transaction is borrowing money from a bank. The acceptance of the cash is an exchange of value: The bank gives a loan and I get the cash.

Cash basis accounting

Under cash basis, revenue and expenses are recognized only when cash is received or spent. For example you make a purchase on credit, with cash accounting you do not recognize the expense till the cash is spent.

Cash basis accounting does not concern itself with accounting events but only accounting transactions. This makes for very poor planning as you cannot see how events will affect your business.

Accrual basis accounting

Accrual accounting recognizes revenue and expenses in the period in which the expense or revenue is incurred, regardless of when cash is collected.

Accrual basis accounting gives a better picture of what your business is actually doing. With accrual basis accounting you are better able to see your true business income because you recognize accounting events as well as transactions.

Let’s look at an example:

George, owner of a fitness small business was paid $7,200 for a a one year fitness consultation. The monthly fee comes out to $600 a month. If George uses accrual accounting, George will only recognize $600 every month for the next 12 months. The remainder of the money does not appear in the income statement because the job has not been completed.  The deferred income ($7200 – $600 in the first month) will appear on the balance sheet as a liability because it is an obligation to the customer.

With cash basis accounting, George will recognize the $7,200 when he receives the cash even though he has not fully earned the money.

As you can see from this example, with accrual accounting George rightfully accounts for the fact that he owes an obligation to his customer. In cash accounting, George treats the money like he has already earned it even though the job is not done and the customer can ask for a refund at anytime.

Accrual basis accounting is the generally accepted accounting principle (GAAP). Which means if you use cash basis accounting you will need to convert to accrual basis before presenting your financial statement to a loan officer.

 

Cash basis versus accrual basis accounting

Any business owner who is serious about growing should use accrual based accounting. Cash accounting is good for the small business who is just concerned about keeping records. It is also good for the cash heavy business where most transactions are cash only.

Accrual basis accounting keeps track of events as well as transactions so therefore, presents a more accurate financial picture.