Cash vs. Accrual Bookkeeping
I would guess that most small businesses, those owned and run by one or two people, use the cash basis of accounting. Under this method, you don’t record any revenue from sales until you get the payment and deposit it in your business bank account. Expenses aren’t recorded until you pay them. You might have a bill sitting in your desk for weeks or months but you wouldn’t know it by looking at your books.
The accrual method, on the other hand, dictates that revenues and expenses are recorded when they occur. So you’ll record an expense when you get the bill. The expense account will increase and so will your accounts payable. Revenue will be recorded when you generate a bill for your goods or services. You’ll increase your revenue or sales account and you’ll increase your accounts receivable.
Which method is the best to use? Well, that depends on what you want. If you want things to be simple then the cash method would be your choice. If you want your books to be accurate then the accrual method is the way to go. With the accrual method you’re recording revenues and expenses together in the same time period. This is a process called “matching” and accountants like it because it will give you a more accurate picture of your profit. Yes, the money you pay and the money you receive occur in different periods from those where the revenues and expenses were incurred and recorded.
Which method do you use on your tax return? It’s a good idea to use the same method on your tax return that you use to keep your books and prepare financial statements. If you carry inventory you must use the accrual method at least for reporting sales and cost of goods sold. Using accounting software such as QuickBooks makes the accrual system much easier to maintain.
If you want to keep track of your cash then be sure to prepare a statement of cash flows. This financial statement shows the sources and uses of cash. Cash comes into your business in three ways: from daily operations (sales), from owner investment, and from financing from loans. Cash leaves the business in the same three ways: paying for daily operations, increasing investment in long term assets, and repaying owners and creditors. The statement of cash flows will answer the question of why you still don’t have any money in the back even though you’ve made a profit.