Cash or Accrual Method of Accounting

There are two methods of accounting that businesses use.  It is either the accrual or the cash method of accounting.  Both accounting methods have their merits.  A business has to choose which one is best for them.

Some people say that cash is king.  The cash method of accounting is based on when money is actually transacted.  My makeup business may sell $10,000 worth of goods in December, but if the money is received in January, then it is recorded on the books for January of the following year.  This is an example of the cash method of accounting.

Cash accounting takes into consideration that things can happen in business.  I may get an order for this makeup, but if the customer changes her mind or doesn’t want it any more for some reason, then I am left holding the goods.  No cash is transacted so nothing is recorded in the company ledger.

Companies get a better view of their high and low points using cash accounting.  The amount of time clients have to pay for their merchandise is reflected in the books.  One thing that can be misleading is when sales take place.  January may look good as a point when a lot of sales are being made, but the sales may have occurred in November only clients took until January to pay.

The accrual method of accounting involves dates instead of actual funds.  If I ship out 500 throw pillows to a store, my books will reflect the sale as the date the truck left the warehouse.  Also, if I buy a new monogram machine for the business, once it arrives, the amount is deducted from my accounts.  I may not pay the other company until thirty days from now, but the transaction is already in my ledger.

The financial view using the accrual method is like looking through rose-colored glasses.  For example, sales may appear to be soaring in the late summer or early fall.  The transactions are recorded, but the money actually came in during the winter.  This can lead to short-sightedness when planning for the following year.

Most companies get to choose which way they want to view the company.  Any business that has less than $5 million in sales in a year can choose between the two methods.  Companies that make more than that amount, or keep an inventory of items that they will sell, are required to use the accrual method of accounting.

Both methods provide part of the financial picture for a company.  Depending on the product that is sold, there are trends that purchases tend to follow.  Seasonal items are an example of this.  How a company wants to look at it is up to them.