There are two accounting standards in the U.S. used for all businesses; cash and accrual accounting. The difference is when income and expenses are accounted for in a company’s books.
The average American engages in cash based accounting on a regular basis, when balancing their checkbooks and paying bills. Money is accounted for as it is received and as it is paid out. The majority of small businesses use this method for bookkeeping, especially when getting started, as it is intuitive and simple. However, as this method fails to take into consideration accounts receivable (A/R), it can give an inaccurate overall picture of the business and its financial state.
The accrual accounting method recognizes revenue and expenses as they are earned or incurred, not when they are actually received. A far more common method for businesses, this method is required for certain types of companies or those with revenue in excess of $5 million. As it takes A/R into account, the accrual method gives a much better view of the financial health of a company.
If a business were to sell a piece of farm equipment and mark it in the books as income when the funds were deposited, that would be an example of cash based accounting. If the sale is put into the books right away, before the payment is received, that is the accrual accounting method.
Of course, expenses are no different. If that same business was to receive a bill for utilities and it is not marked as an expense until the payment is made, that’s cash based accounting. The accrual method would have that business recognizing the expense as soon as the bill is received and not when it is actually paid.
Why is it important to know the difference? So you know what method is right for your business and at what point. Starting out, it’s often easiest to use the cash based accounting method. As your venture grows, it is important to understand what accrual based accounting is and how it may help your business scale by taking a holistic view of your company. Or to know if it’s an IRS requirement for your situation.
As always, when making a decision regarding financial matters for your business, it’s important to do your research and to consult an accounting professional.