The two most common types of accounting are cash and accrual. They each have their own strengths and weaknesses, which is why many businesses use a combination of the two methods.
The basic idea of cash accounting is straightforward: revenue is recorded when money comes in, and expenditures are recorded when money goes out. This makes it easy to track your financial progress on a day-to-day basis, as well as during specific time periods. However, it’s not as effective at tracking financial progress over the long term, since income and expenses that haven’t actually been paid yet won’t be reflected in the books.
Accrual accounting is more complex, but it’s better at tracking long-term financial progress. Revenue is recognized when it is earned, no matter when the money comes in, and expenses are recorded as soon as they are incurred, regardless of whether the cash is paid or not. This means that accrual accounting can more accurately reflect a company’s financial health, even if some of the revenue and expenses haven’t actually been paid yet. However, it can be more difficult to track your day-to-day finances using this method.
Cash Basis Accounting Definition & Examples
A cash basis accounting system records revenue and costs when money changes hands. The accrual approach, on the other hand, differs from this in that revenue and costs are recorded when they are incurred (when a liability is incurred or an asset is received, regardless of whether cash has actually changed hands.)
The “cash basis” means that income and gains and losses on fixed assets aren’t counted until cash changes hands: until then they remain in “enterprise” (or “capital”.)
Accrual Basis Accounting Definition & Examples
Accrual accounting is a type of accounting in which expenses and revenue are recorded as soon as they are incurred, regardless of when the money is received. This is in contrast to the cash basis, which records revenue and expenses when money changes hands.
Income and gains and losses on fixed assets aren’t taken into account until money changes hands under the “accrual basis. Until then they remain in “enterprise”.
What Does It Mean To Record Transactions?
The process of documenting a financial transaction is to include it in the company’s accounting records. This can be done in one of two ways:
- Cash basis accounting: When cash comes in, revenues are recorded, and when cash goes out, expenses are recorded.
- Accrual basis accounting: Revenue is recorded when it’s earned, regardless of when the cash comes in, and expenses are recorded when they’re incurred, regardless of when the cash is paid.
The Effects of Accrual and Cash Accounting Methods
The material impact of choosing one accounting method over the other is that it will affect how various financial statement line items are presented. Two examples are:
- Income Statement Line Items: Accrual basis operating income/profit will be higher than cash basis, due to revenue being recognized when earned instead of when collected. Cash basis expenses will be lower than an accrual basis, due to recording when paid instead of when incurred.
- Balance Sheet Line Items: Accrual basis net assets (assets – liabilities) will be higher than cash basis, as the former includes accounts receivable and inventory, which are not included in the latter. Cash basis current liabilities will be higher than an accrual basis, as the former only includes accounts payable (which are due to be paid within one year), whereas the latter also includes unpaid liabilities that have been incurred but not yet paid.
Which Type of Accounting Is Right for Your Business?
Ultimately, which type of accounting you should use depends on your business’s needs. If you need assistance with your business’ accounting in the Raleigh-Durham area reach out to us today at (919) 872-0866 or fill out the form below to get started.