Well, since this is such a new blog, I don't have any subscribers yet which means that there is nobody to request that I write about a particular accounting topic that is giving them heartache. I've spent a lot of time doing books and auditing companies all across North America and it seems like companies always have a difficult time with this whole cash vs. accrual thing. So this week, we are going to talk about the difference, how it will affect your books, and how to set up your bookkeeping system to make it work for you.
Let’s figure out this cash word first and then we'll talk about accrual.
These terms refer to how you are recording your transactions in your books. A company can go down the cash road or the accrual road, but once a method is chosen, the company should stick with it. You can change, but for the sake of consistency, don't unless you have good reason. In case you are wondering, most companies do the accrual thing. I run Dashboard Accountants on the accrual basis and it is much more accurate. Let’s talk about what they mean.
Cash basis accounting: Alright, put on your accounting caps and imagine with me a company that records transactions only when cash is received, or when cash is paid out. Let’s do an example, shall we? Let’s say pops lawn care shop mowed your lawn today. What would that mean for their accounting records?
1. They did something that generated revenue for their company.
2. While they did the service, they also incurred costs that they had to deal with. For example, the cost of the guy mowing the lawn, the cost of gas in the lawn mower...etc.
3. You had a service performed that you now have to pay for.
So, let’s say the guy’s packing up his lawnmower and then he knocks on your door to collect payment. What you do next will determine how the accountant for pops lawn shop will record the transaction in the books. You can do one of two things.
1. You can say oops! Sorry, I don't have any cash. Can I pay you next week?
2. You pay the cash right there on the spot.
If you don't have cash, he will go back to the accountant empty handed. Now, because cash was NOT received, the accountant does not record a thing. A week later when you make your payment, the accountant will get the cash and then he or she will enter the transaction. Remember, pops lawn shop is using the cash basis method of accounting so nothing was recorded until cash was received. TO go along with that, the expenses incurred will not be recorded until pops cuts a check to the lawnmower or to the gasoline vendor.
Now assume you had paid your cash the day the lawn was mowed. The accountant would have recorded the transaction that very day.
So why do some companies use the cash basis method? The only argument for using the cash basis is that it is easy to do. You only record a transaction when cash is received.
Why do most companies use the accrual method (Which we will talk about tomorrow)? The cash basis method doesn't represent what really happened. That’s the problem. If you as a business owner who want to make better decisions, you need to have financial statements that reflect what really happened. If you are a business owner who does not want to make better decisions, stop reading…this blog is not your cup of tea. Go play video games or something. If you are still here, then well done! You can add yourself to the elite group of business owners that care about their businesses.
So now you’re asking, “how is recording the transaction a week later inaccurate?” Well, the answer is in the question; the service happened a week ago. Humor me for a minute, but what if pops mowed the lawn on December 31st? (Bad time to mow the lawn I know, but stick with me on this). You would have done the work during one year, and then recorded the revenue earned and expenses incurred the next year. That's a problem. So, what’s the solution you ask? Is your company recording transactions like pops? Then tune in next time for the stunning conclusion to our discussion on cash vs. accrual; Same blog address, same blog time. I know you'll be waiting in shear suspense!
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