Small business owners are often asked by bankers, investors, and other interested parties about which method of accounting they are using to produce their company’s financial statements. The person reviewing your financial data needs to know this so they can accurately review the numbers presented them. Both the accrual and cash methods are accepted ways of recording transactions, but each method sometimes gives very different results in your bottom line profit.
The cash method of accounting is the most commonly used method. It is the easiest way to record transactions and can normally be done by the business owner and not an accountant. Simply put, the cash method records money when it comes in, and money when it goes out. It is basically a mirror image of your business account check register. For example, when a customer pays you money for goods and services, you then record the sale in your books. When you write a check or pay cash for an expense that is the moment in time when you enter the expense in your books. It’s as simple as that. Most all small businesses can use the cash method of accounting if they wish, unless they carry inventory and average over ten million dollars in gross sales in the three prior years of business. If your business falls into this category, you must use the accrual method of accounting.
The accrual method of accounting is the “correct” way to compile your financial statements. If you hire a CPA to compile your financial statements, they will produce your financial statements in accordance with “GAAP” (Generally Accepted Accounting Principles). This simply means that they will use the accrual method of accounting. What does accrual mean? The timing of your business revenue and expenses are better matched with this method. You record the sale of goods and services when they are invoiced or the job is complete. It does not matter if you have collected the money yet or not. Expenses are also recorded in the company books when they are “incurred” or due and payable. They are not necessarily recorded when they are paid. This type of accounting will give you a better picture of how your business is actually performing and should be used when analyzing your business profits.
Neither method of accounting is wrong or right. It is up to the business owner or his accountant to determine which method will be used.
