Before anyone starts keeping books for any business entity they have to decide which method of accounting they are going to use.
Luckily, there are only two methods available to choose from; the Cash Basis method or the Accrual method. The difference between the two methods is dependent on when we recognize income and expenses in our set of books. In formal accounting this is referred to as the Matching Principle.
The Cash Basis Method of Accounting
If you are going to keep your company books on the Cash Basis Method of Accounting you recognize income only when it is received. This means you have to receive cash, check or a credit card payment from your customer before you record income in your books. Having a customer owe you money is not income on the Cash Basis Method of Accounting.
The only time you can record an expense in your books is when you actually make a payment by cash, check or credit card. Simply owing money to your vendors or anyone else is not considered an expense until paid.
The Cash Basis Method of Accounting is the easiest form of accounting to utilize. It doesn’t require you to know as much about formal accounting. This method is especially useful for small businesses that pay their bills in the same month they receive them and who receive payments from their customers in the same month as the work is performed.
This method of accounting is used a lot by small contractors and other service based businesses because of its simplicity.
The Cash Basis Method of Accounting is also used by accountants everywhere when a client brings in an entire year of work, in a box, that needs to be put together. Many small businesses will wait to do their bookkeeping after a number of months have gone by. When this happens the only practical method of doing the company books is by the Cash Basis Method of Accounting.
The Cash Basis Method of Accounting is illustrated and described with detailed lessons in the eBook QuickBooks Made Fast and Simple, which is available at QuickBooksTutor.com.
Most taxpayers in America also file their income taxes each year on a Cash Basis so this is an ideal method of accounting to follow if your company does business in the manner described above.
The Accrual Method of Accounting.
The accrual method of accounting recognizes income, when it is earned. You don’t have to receive a payment from a customer to record income on the accrual basis. If you have done the work and you invoice your customer it is recorded as income earned in that month.
It is the goal of the accrual method to invoice customers for money earned in the month the work was performed. This has nothing to do with when the money is actually collected.
The monies your customers owe you, but have not paid, stay in an account called accounts receivable, until they are paid.
We record expenses on the accrual method when the expense is actually incurred. This means you record every bill and expense your company receives, in the month it is actually received. Regardless of when you pay the bill. You might not pay a bill for 30 days or more, but on the accrual basis it is recognized as an expense in the month it is incurred.
The reasoning behind the accrual method is that we are trying to accurately match the income the company earns for a specific time period with the expenses the company incurs for that same time period.
If this is done correctly we will get an accurate measurement of the profit or loss for a business for any given month. This is considered the more accurate of the two methods of accounting because it strives to match income and expenses for the same period of time.
The accrual method of accounting requires more knowledge of accounting procedures than the cash basis method and does require more work, but is generally regarded as the more accurate.
Analysis of both methods of accounting
Some company’s who utilize the cash basis method still achieve the same accuracy with their financial statements as the accrual method, if they receive their income and pay their expenses in the same time period.
Lending institutions almost always want to see the company financial statements prepared on the accrual basis. If your business keeps their books on the cash basis method it is not very difficult to adjust the books to include all the necessary accruals and therefore satisfy the needs of the lenders.
A lot of businesses keep their books on the accrual basis but file their income taxes on the cash basis. In this case it becomes necessary to adjust the books back to the cash basis of accounting for tax purposes.
QuickBooks has an automatic feature that will adjust your books to the cash basis method if you have been keeping your books on the accrual method. This automatic feature does not work in reverse.
Larger companies will generally use the accrual method so they can track their accounts receivable and accounts payable accounts more accurately. These larger businesses will also want to accrue other expenses each month like depreciation and interest expenses that are not recorded the same way on the cash basis.
Smaller companies can use either method but most really keep their books on the cash basis method since it requires less knowledge of accounting and it is the method they need to file their income taxes.
As you have seen with the previous examples it is possible to keep your books using either method of accounting and simply adjust the books to the other method if needed.
QuickBooks was designed to be used on the accrual basis and there are hundreds of books on the market designed to help teach you this method.
However, if you feel the cash basis of accounting is better suited for your business and your knowledge of accounting then take a look at the only book in the world that shows you how to use QuickBooks on the cash basis at QuickBookstutor.com.