In business accounting, there are two methods of accounting for income. One is the cash based system, and the other the accrual method. Choosing which one to use is an important decision for the company’s leadership to make, and can have lasting effects on a company’s business practices and health.
The cash based system of accounting records income as the money is collected and expenses as the money is actually paid to the creditors. Not included in revenue are sales for which the money has yet to be collected, and also, accounts payable that haven’t been paid yet are not counted as expenses. This system is fine for small entities, as it is a simple system of accounting and does not take many resources to implement it. Likewise, companies that do not have any issues with collecting on their accounts receivable, such as those which are primarily or exclusively paid with credit cards, can also get away with the cash based method of accounting.
The main problem with this system is that it can be tough to get an accurate picture of the company’s performance. You simply cannot take such a company’s financials, point to a month and say, “This is how much money the company’s sales generated, and this is how much money those sales cost.” Since there is usually a gap between making a sale and collecting the money, and also between using a resource and then paying for it, there can be a lot of overlap in cash flow from one period to the next.
A much better method, and one that is generally required of companies that have to publicly report their financial statements, is the accrual basis. This method follows the revenue recognition principle, which dictates that all revenue is recorded when it is earned, regardless of when it is actually collected. In addition, all expenses are recorded when they are recognized and not when the cash is actually paid.
To implement this method, four accounts exist to balance the money that does not physically change hands when an event is recorded in the accounting system. Any revenue that is recorded before the actual cash is received goes in the Accrued Revenue account. The Accrued Expense account contains any expenses that are recognized before the money is paid to the creditors. In the Deferred Revenue account, revenue is placed that is received in anticipation of goods or services that have yet to be provided. And finally, the Deferred Expense account holds expenses that have been prepaid, but for which the company has not yet received the goods or services. Assets include the contents of the Accrued Revenue and Deferred Expense accounts, and the contents of the Accrued Expense and Deferred Revenue accounts are considered liabilities.
Through the accrual accounting method, companies can get a better picture of how the company performed during a certain period of time, without the latency of the money actually changing hands to skew the numbers. Companies with revenues of less than a million may be able to get by with the cash based accounting method, but for businesses that are medium-sized and larger, accrual based accounting is a much better way to account for the company’s financial performance.