Which Accounting Method is Best--Cash or Accrual
Which Accounting Method is Best--Cash or Accrual
Which Accounting Method is Best--Cash or Accrual
The cash method and the accrual method of accounting are the two main methods of keeping track of a business's expenses and income. The method a company chooses is often dependent upon which is simpler and serves all the different purposes of that business. Basically, the main difference in the two methods is timing of when transactions are debited or credited onto the business's books.
Small businesses tend to favor the cash method. The cash method means the business does not count any income on a product sold or a service rendered until payment is received, and expenses are not counted until the business makes payment on any goods purchased or any services done for them.
An example:
A company purchases a new computer for $2000 on credit in August and pays for it in November, 90 days later. Under the cash method of accounting, the business would record the $2000 cash payment for the month of November which is the month the money is actually paid. In the accrual method, the $2000 payment would get recorded in August when the purchase took place.
Transactions are recorded when the order is made, item delivered or services have been rendered, regardless of when payment takes place under the accrual method. Under the accrual method, it is not always easy to find out when a purchase or sale has taken place. For those businesses using the accrual method of accounting, the important date is the date the job was completed or sale or purchase made.
An example:
A department store sells 5 easy chairs, all purchased on credit for a total purchase price of $1500. The department store will record these transactions the same day the purchases were made, regardless of the fact that each of the people purchasing the chairs will undoubtedly send their payment at different times in the future.
There are advantages and disadvantages of using either method of accounting. One of the main advantages of the accrual method is its ability to show the ebb and flow of a business's income and their debts more accurately, which helps their lenders to quickly see how a company is doing. Although, it does tend to leave the company in the dark about what is available in their cash reserves, which in turn could mean a serious cash flow problem. It is important to understand that if a company using the accrual method is looked at in the vacuum of a one month period that on paper makes them look really good due to a high volume of sales, they may in actuality be cash poor because the company's customers haven't paid for those purchases.
There is another disadvantage when using the accrual method for tax purposes. It is obviously more difficult to minimize taxes by shifting items of expense and income from one year to another when the accrual method is used. A business could try to control expenses and income by deferring some income to the next tax year by shipping and invoicing as little as possible during the closing days of the year; however, that might not be worth the cash-flow problem it could cause.
There are also advantages and disadvantages when using the cash method. Although, the cash method of accounting gives a much more accurate picture of just how much cash a business has on hand at any given time, it could give a misleading picture of the longer term profitability of said business. Again, if someone were to look at a company's books for just one month and that month showed a very high profitability rate, their assumption that the company was healthy could be incorrect. It might only mean that a lot of previous sales made on credit were paid during that month, and, in fact, the company may have had few actual sales during that month.
Some companies don't have the luxury of choosing between these two methods. Small businesses that have sales of less than $5 million dollars per year are allowed under the law to choose either method.
The accrual method of accounting is required under the following circumstances:
A business has sales in excess of $5 million dollars per year, or
A business stocks an inventory of items that they will sell to the public and the gross receipts exceed $1 million dollars per year (Inventory includes any merchandise sold, along with any supplies that will be used to make or become part of an item intended to be sold)
Regardless of the accounting method chosen by a company, it is important to understand that neither one gives a full picture of the financial status of the business.
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