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Cash vs. Accrual Accounting

There are two basic accounting methods available to most
small businesses: cash or accrual.

Cash method. If you use the cash method of accounting, you
record income only when you receive cash from your
customers. You record an expense only when you write the
check to the vendor. Most individuals use the cash method for
their personal finances because it's simpler and less
time-consuming. However, this method can distort your income
and expenses, especially if you extend credit to your
customers, if you buy on credit from your suppliers, or you
keep an inventory of the products you sell.

Accrual method. With the accrual method, you record
income when the sale occurs, whether it be the delivery of a
product or the rendering of a service on your part, regardless
of when you get paid. You record an expense when you
receive goods or services, even though you may not pay for
them until later. The accrual method gives you a more
accurate picture of your financial situation than the cash
method. This is because you record income on the books
when it is truly earned, and you record expenses when they
are incurred. Income earned in one period is accurately
matched against the expenses that correspond to that period,
so you get a better picture of your net profits for each period.

Pros and cons. The cash method is easier to maintain
because you don't record income until you receive the cash,
and you don't record an expense until the cash is paid. With
the accrual method, you will typically record more transactions.
For example, if you make a sale on account (or, on credit),
you would record the transaction at the time of the sale, with
an entry to the receivables account. Then, when the customer
pays their bill, you will record the receipt on account as
another transaction. With the cash method, the only
transaction that is recorded is when the customer pays the bill.
If you are using computer software to do your accounting, this
is probably not a big concern, since the computer program
automates much of the extra effort required by the accrual
method.

Another issue to be considered is the accounting method you
use for tax purposes. For convenience, you probably want to
use the same method for your internal reporting that you use
for tax purposes. However, the IRS permits you to use a
different method for tax purposes. Some businesses can use
the cash method for tax purposes. If you maintain an
inventory, you will have to use the accrual method, at least for
sales and purchases of inventory for resale.

We recommend the accrual method for all businesses, even if
the IRS permits the cash method, because accrual gives you a
clearer picture of the financial status of your business. You
probably need to keep a record of accounts receivable and
accounts payable anyway, so you are already keeping track of
all the information needed to do your books on the accrual
basis. If you are using a computer program, there really isn't
much extra effort involved in using the accrual method.