I'd like to talk with you all about cash vs. accrual accounting. These are two different ways that a company can track income and expense. There are some fundamental differences between the two ways of managing and reporting financial data (methods of bookkeeping) and the idea of accrual accounting can be difficult for even the best of us to comprehend. Let’s get started!
Cash Accounting
Cash accounting is a method of accounting that records income when cash is actually received and records expenses when cash is paid out (when cash is actually exchanged). Of the two methods, cash accounting is the most basic way to track and is very straightforward. The last “Controller’s Corner” newsletter talked about cash flow forecasting – cash accounting allows a small business an immediate and up-to-date snapshot of cash flow and cash balances. Many sole proprietors (i.e. the small landscape company that mows your lawn or your local barber/hairdresser) will most likely keep track of their finances using the cash method of accounting. This way of accounting is good for small business with little to no debt or loans on the books.
Accrual Accounting
Accrual accounting is the method of accounting we use here at Coleman. The accrual method is where revenues and expenses are recorded when a transaction occurs vs. when payment is received or made – it follows the matching principle guideline of accounting. The matching principle states that a company must report its expenses in the same period in which the related revenues are earned – here’s a brief article about the matching principle: https://www.accountingcoach.com/blog/what-is-the-matching-principle (a little late night reading).
Examples of general ledger accounts that are based on accrual accounting are: accounts receivable, pre-paid expenses, accrued revenues, accounts payable, and deferred revenues. When we create our first draft of month-end financials, we are looking at the profit and loss statement to see if we have expenses on the books for that period (one month) that don’t have corresponding revenues or vice versa. If we see revenues or expenses that we should have been recorded, we “accrue” for those items. By using the accrual method of accounting and following the matching principle, we have clean books that reflect actual profitability of the company and we can see how we are performing in a given period of time.
As the article I shared above states, there is a cause and effect relationship of costs to revenues, but not all costs are revenue drivers. Some costs are supportive in nature (i.e. administrative salaries) but should be reflected in the period used. Clear as mud? A lot of accountants who have primarily worked in a cash accounting environment struggle with the accrual concept – so you are not alone!
