Question: In one sentence, how would you describe the difference between the cash and accrual methods of accounting?
Understanding these two issues is at the heart of the accounting basics: Let’s discuss the difference between the cash vs. accrual methods of accounting, and that will lead us into the matching principle.
The cash accounting method is amply named. When using this method, transactions are recorded (i.e. your books are impacted) on the date that cash changes hands. A way of simplifying what this means is to think about an employee’s taxes. She works for a company that gives her a W-2 at the end of the year, which shows all of her earnings. These numbers reference what she was actually paid in that tax year. Even if she received a bonus on January 1st of the following year for a sale related to the prior year, she wouldn’t pay taxes on it until the following year.
Some small businesses also use the cash method of accounting. If you have a small business with no inventory, this is a valid way to track things. It gets much more complex when inventory gets involved.
The accrual accounting method doesn’t care when cash moves; it cares when the “economic event” occurs. Thinking of your income statement, this means two main things: 1) revenue is recognized when it is EARNED, not when the customer is paid, and 2) expenses are MATCHED to the BENEFIT that they relate to, whether that’s the related revenue or an asset of some kind.
That leads us nicely into the matching principle, which 2 examples will make very clear: In the accrual method of accounting 1) If you pay me $10,000 today for an agreement that I will complete work over the next 6 months, none of that money is income today; it will be spread over the next 6 months as I earn it. 2) On the flip side of the coin, if I purchase a $50,000 machine that will be used in the company for 5 years, it’s not an expense upon purchase; the expense will be spread over the 5 years that it benefits the company.
One big thing to remember, regardless of which method you use, is that you have to file your taxes under the same method as how you keep your books. Which method makes more sense to you? Which will you use?