In accounting, two of the practices used to ensure the accurate maintenance of financial data are Accrual Accounting and Cash Accounting. Though they have several similar components, they also have clear differences which we will try to define in this article.
The Accrual Accounting model records revenue at the time it is actually earned and expenses at the time they are billed. For example, if you complete a job today and issue an invoice at the time the assignment is completed then Accrual Accounting will recognize and record that revenue as one of today’s assets. Even though your client may withhold payment for several weeks, under the Accrual method the revenue must be entered at the same time as the invoice…not the payment. The Internal Revenue Service (IRS) actually requires any business that maintains inventory to utilize the accrual method.* In the Accrual Accounting process, a business will post the money owed by a client to a receivables account. Once the bill is paid, the business records the payment, which ultimately decreases the amount in the receivables ledger. The same approach is applied to expenses. Any fees connected to revenue-related activities, must be entered in the payables column at the time the goods or services are obtained. Although payment may be delayed for a period of time, the expense must be recorded when the activity actually takes place.
Cash accounting, sometimes called Cash-Basis Accounting, records income at the time payment actually takes place, rather than when an invoice is issued. For example, if a client pays an invoice two weeks after services are rendered, the payment is entered as an asset on the day that payment is received. The same holds true for accounts payable. Debts and expenses are not recorded until the day they are paid.
Under certain conditions, the IRS will permit the use of a combination of Accrual and Cash Accounting. Because this method is ambiguously defined and complicated to manage, its application is best left to an accounting professional. The IRS will only approve this method when it has been used on a continual basis because it has proven to be the most accurate means of presenting a business’s financial records.
Naturally there will be instances requiring entries to be adjusted. Circumstances requiring modifications are complex and can be difficult for an untrained eye to recognize and reconcile. A small business Accountant will have the necessary knowledge to determine if an adjustment is required regarding unrecorded revenue and/or expenses. If such a determination is made, the Accountant can then make the correction accordingly. These changes are referred to as adjusting entries.
Now that you have a better understanding of the two basic types of accounting used in businesses, ask your Accountant for advice on the best procedure for you.
*There is an exception to this directive. Businesses that average annual gross receipts of $1 million or less over the previous three years are not required to use the accrual method.