If you’re like most people, accounting and accounting-related jargon sounds like a different language. For anyone without an accounting background or related education, it can be challenging to understand even the most basic accounting principles.
One of the questions we hear frequently has to do with the cash and accrual accounting methods and which would be the most beneficial for a particular situation.
In this article, we’re going to use layman’s speak to explore how each of these methods are similar, how they’re different, and scenarios where each should be used to give you a better idea of how we implement these methods in various accounting operations.
A Brief Overview Of Each Method
To put it in very basic terms, the cash method of accounting is probably what you do for your personal finances. Or, you may also use it if you own a small business that makes less than $5,000,000 per year (we’re not just pulling that number out of the air–$5,000,000 is the IRS cutoff for the cash accounting method). This method is considered easy from an accounting standpoint. Still, it does not necessarily show an accurate representation of profit over time due to the random cash inflow.
On the other hand, the accrual method of accounting is more complicated. However, it does make more sense for higher-volume companies in the long run to show profitability. Instead of recording income and expenses based on when they enter and leave your account, the accrual method bases income and expenses on when they’re earned and billed, respectively. This method gives larger companies a better idea of their total revenue, even when they have invoices with an outstanding balance.
How The Cash Method Is Properly Used
Most people are taught the cash method from an early age, making it second nature when you use it for a business. This method is quite simple to use and understand. When money leaves your account, you record it as an expense. When you deposit cash into your account, you register it as income. If it sounds uncomplicated and straightforward, that’s because it is!
For example, say that you’re a handyman and go to someone’s home to patch some drywall. When you finish, they hand you a check for $150, and you immediately go to your bank to deposit it into your account. When you use this system, there is no need for invoicing or complicated billing procedures. Therefore the cash method is what works most effectively and efficiently for your business.
How The Accrual Method Is Properly Used
There are instances where using the accrual method of accounting is not only necessary but required. As mentioned above, any business reporting over $5,000,000 of income is required by the IRS to use the accrual method. In addition, sometimes, it’s not possible to get paid without first sending an invoice, which can cause issues with the flow of income if your customer doesn’t pay the invoice expediently.
If you send an invoice to a customer using the accrual method, you will count that as income even if you haven’t received payment for the invoice. The main benefit to the accrual process is pinpointing which months are profitable and why to understand better and strengthen your business’s margins.
We’ll use the same handyman as before for this example, except our handyman has now expanded his business. His new business model is to send the customers an invoice after his employees have finished their work for the total amount of labor and materials. His payment terms are generally Net 30, meaning he gives his customers 30 days to pay before they begin accruing interest and late fees.
Since he’s completed the work and sent an invoice, our handyman still needs to show income each month even if their customer doesn’t pay for a month after their service. For him, using the accrual method of accounting will accurately show income each and every month due to outstanding invoices, even if the balance in his bank does not reflect this income until the invoice is paid.
If You Have Questions, We Have Answers!
This fundamental and simplified article should give you a great foundation and a general understanding of cash and accrual accounting principles. Still, we understand that short articles don’t always answer every question you have about a particular topic.
Here at JStevens Accounting, we pride ourselves on our service. We want our current and prospective clients to know that we’re here to demystify the accounting process.
We’d love to be your resource for all of your accounting questions and needs!