This is the method by which revenues are
recorded when earned, and expenses are recorded when they are incurred, as
opposed to a cash-basis method of accounting that measures revenue when cash is received and
expenses when they are paid. The accrual method must be used for financial
statements to be considered prepared according to Generally Accepted Accounting
Principles (GAAP).
Accrual
vs. Cash Basis Accounting
For the non-accountant, this topic can seem
as mysterious as the Egyptian pyramids. When working with basic small business
financial statements, the accrual concept is easy to understand. However, in more complex
business environments accrual accounting can become as exacting and tedious in
its application as nuclear physics. Fortunately, we are going to be discussing
the former, not the latter. You have read the definition of accrual vs. cash
(above) so let’s use one of the most common examples of accrual accounting
found in small businesses, i.e., Accounts Receivable and Accounts Payable.
First, you must be familiar with how debits and credits work.
Let’s say you are in the business of selling
T-shirts. Today you sold four T-shirts for $10 each. Two of the T-shirts sold were paid for
with cash, i.e., $20. The other two were sold “on account”. In other words, the
customers said they would pay you later. These two transactions have to be
recorded differently on your books. Here is the journal entry for the first
transaction.
You decreased the Liability and decreased
Cash. These are examples of the difference between an Accrual transaction and a Cash
transaction. Which one is better? It is not a question of better, it is a
question of accuracy. If you include all accrual transactions on your books,
the reader will have a more complete understanding of what is going on in your
business than if only Cash transactions are recorded. Think about it with our
examples. The Accrual transactions would show more Assets, more Liabilities and
more Revenue than the strictly Cash transactions.
This reflects all the activity going on
instead of just a portion. This is why the Financial Accounting Standards Board
(FASB) requires that financial statements that are prepared using Generally
Accepted Accounting Principles (GAAP) use the Accrual method of accounting.
Either way, the point is that you can do it
and there may be good reason to do so. You may have high receivables and low payables.
This means you could be in for a double-whammy. You will have to report high
income and low deductions. This means your taxes will be higher while not
having received the cash to pay those taxes. Keep in mind though that you can’t
switch back and forth each year from accrual to cash.
Once you select the method of accounting for
your tax return, you have to stick with it. Otherwise, you will have to have permission
from the IRS and a very good reason for requesting a change in accounting method.
Many people use a hybrid system. This means
using a combination of accrual and cash basis methods when preparing financial
statements. Most often, a business will record only Accounts Receivable and
Accounts Payable accrual items. In addition, the only Accounts Payable items
recorded will be Inventory purchases, since most of the other expenses of the
business are paid within 30 days. The value of using the hybrid system is that
your financial statements reflect all Revenue and all Inventory purchases. Plus,
it is fairly straightforward when adjusting for a cash basis tax return at the
end of the year.
(By John W. Day, MBA)
