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There are two methods of accounting that businesses typically use. One is called the cash method of accounting, and the other is known as the accrual method of accounting. Each system has its merits. A business must therefore choose which of the two is best for its own specific operation and needs.
The cash method of accounting is based on when money is actually transacted; in other words, when funds in point of fact change hands from buyer to seller. For example, if you operate a small business that sells an order of $10,000 worth of merchandise in October, but the money is not actually paid and received into your account until December, then it's recorded on the books for the month of November. This is the cash method of accounting in action.
Cash accounting takes into consideration that unexpected things can and often do happen in business. For instance, after you received the $10,000 order, if the customer changes his or her mind and simply doesn't want it any more for whatever reason, you're left holding the goods. But no cash has been transacted, so nothing is recorded in your company's financial ledger.
Companies can get a better view of their high and low points using cash accounting. The amount of time that clients take to pay for their merchandise is reflected in the books. However, one thing that can be misleading is when sales take place. At first glance, November may look like a great time when a lot of sales are being made, but those sales may have actually occurred in September and October, and the clients simply took until November to pay.
In direct contrast to the cash method, the accrual method of accounting focuses on dates instead of when funds actually change hands. Let's assume your small business uses this system and not the cash method of the previous example. You fill and ship out that $10,000 in merchandise to your customer as soon as you get the order, and your books will reflect the sale as the date that the truck left your warehouse. Furthermore, when buying materials from one of your suppliers, as soon as the goods arrive in your possession the amount due is deducted from your accounts. You may not actually pay the supplier until thirty days from now, but the transaction is already entered into your ledger.
The financial viewpoint using the accrual method can be likened somewhat to 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 won't actually come in until sometime during the winter. If not careful, this can lead to short-sightedness when planning for the following year.
Any business that makes less than $5 million a year in sales has the option to choose which method works best for it. Companies that make more than that amount, or that keep an inventory of items to sell, are required by the IRS to use the accrual accounting method.
