In a for-profit business, there are two ways to do the accounting: 1. Cash Accounting or 2. Accrual Accounting. Businesses need to decide between cash vs accrual accounting. Cash accounting is what many small businesses use. Expenses are recorded when paid for and revenue is recorded when collected. As long as the bank accounts and credit cards reconcile, everything is accounted for. Accrual accounting, on the other hand, is a little more complex, but gives better insight to a business.
Accrual accounting operates with the matching principle, which was explained in an earlier blog post. The revenues and expenses are matched to the period that they relate when using the matching principle.It doesn’t matter when expenses are paid for or when revenue is received, they are recorded when incurred. For example, you receive a bill for services performed in January, but don’t pay it until the end of February. Under cash accounting, this would be recorded in February when it was paid, but accrual accounting accrues for this expense in January, when the charges were incurred.
While this is a little more tedious, it creates a more useful tool for your business. Numbers are easily manipulated if you only use cash accounting. For example, if I want my expenses to look better in this month, all I have to do is wait a week to pay a bill and it will be included in next month’s expenses. For most businesses, operational expenses are pretty stable, with little variation from month to month, but cash accounting doesn’t always reflect that. When things are matched to the correct period, it is easier to analyze and plan. Whereas, in cash accounting, things can be very volatile from month to month; which makes it hard to analyze and figure out what needs to change to improve your business. When things are relatively stable, it is easy to figure out if this month was better because you found a way to cut expenses or because you sold more products. While this is very simple analysis, reports using accrual accounting can provide much more insight to your business.Written by: Ashley Peth TGG Accounting