There are two different types of accounting that businesses use: cash accounting vs accrual accounting. Most businesses use accrual accounting, but it varies by the type of business. These two methods are both legal and accepted by the Internal Revenue Service. The primary difference between the two is when income and expenses are recorded in the books. When thinking about cash basis accounting, picture a lemonade stand. When thinking about accrual basis accounting, imagine a grocery store.
Cash accounting is simply recording transactions in the books when money changes hands. This excludes accounts payable, accounts receivable, and anything that has not caused a monetary transaction. A lemonade stand would use cash accounting because of its simplicity. The books of a small juice stand would not reflect payables on credit from suppliers. It would not show an anticipated receivable from customers. Another example of a cash accounting business might be a consultant. By deciding the most tax-friendly times for payments and expenses during the year, a consultant can minimize taxes due. This is not tax invasion; it is just deciding when he or she will collect payments for his or her services.
Some argue that this method fails to adhere to the matching principle. In cash accounting, revenues and expenses from the same period are not recorded as accurately. For example, if you sell 100,000 widgets in December but receive payment in January, cash basis accounting will recognize that revenue in January—the next accounting year. This can have unwanted effects on how much taxes are due.
Accrual basis accounting is the widely-accepted method for most businesses. In fact, some businesses require that they use accrual basis, depending on the amount of sales. When they are made, accrual basis accounting records transactions. Record sales before the money enters the company even if it sold the product or service on credit. It also means to record expenses as they are accrued.
Here’s another example to exemplify the difference: a company decides to purchase all new inventory. The entire purchase is realized even if it is not paid for yet. Think of the implications of this at the end of a year. A company could make a large purchase at the end of the year to minimize the taxes due for that period. This will increase revenue, and therefore taxes, for the following year. This example shows it is possible to distort the matching of income and expenses using accrual basis as well as cash basis accounting.
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