FYI… Cash or accrual accounting
You'll often hear the terms cash or accrual accounting. Is this when you tune out? They're the two main methods of keeping track of income and expenses. They work in different ways so it's good to understand how your financials are put together.
The cash accounting method records income in terms of the date the cash is actually received and not necessarily the date when the sale was made. In the same way, expenses are recorded as at the date you actually made the payment, and not the date when you committed to the outlay. With credit transactions, the key date is when it's charged to the card.
With the accrual method of accounting, income is counted from the date the sale is made (and that might be the date the customer put in their order or the date of delivery, depending on your terms). In the same way, expenses are counted as at the date you committed to the outlay. Sometimes it can be a little confusing to work out the date of transaction. The job completion date is all important here. If everything to do with the purchase has been received and installed, the job is complete and it can go on your books at that date.
Many smaller businesses use cash accounting as that suits them best. However, larger businesses use the accrual method. It is also important to note that generally businesses are required to recognise income on an accruals basis for calculating income tax. Therefore even if a cash accounting method is used for budgeting or cashflow purposes, adjustments for accrual accounting will be required to determine the correct amount of tax payable.
Cash vs accrual accounting - pros and cons
The advantage of cash accounting is that it's easier to understand. You see exactly what your cashflow is and you can see your cash reserves clearly. The disadvantage is that you don't have an easy way of tracking how much money you owe your creditors or how much money your debtors owe you. It doesn't take future expenses into account. So it can sometimes be hard to assess long-term profitability in your business and it can be hard to spot the risks where money you owe will undercut your incoming revenues. As mentioned above, your income tax payable will also need to be calculated using the accrual method of accounting, so adjustments will be required to determine your tax liability.
The advantage of accrual accounting is that it's easier to see amounts owed by debtors (so you can do something about them). It's a more accurate picture of activity in your business for any given period. You can see the sales you've made and your costs, regardless of when the money is actually received or paid out.
The downside is that it is more complex to administer. It's where the so-called double-entry bookkeeping system comes into the picture (let's leave that for another day). It may be necessary to make accounting adjustments at the end of the reporting period to account for sales which have been made but the money has yet to be received for them. Similar adjustments will be made for expenses incurred but not yet paid for. Generally, making these adjustments for you is where we come in.
If you want to know more about what method is used for your business and how it works, call us.
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