In the accounting world, there are two main ways of preparing your books and financial statements. These two methods are accrual and cash. Although they have some similarities, there are large enough differences between the two to make accrual the most widely used because of its greater accuracy.
For statement purposes, accrual accounting is much more fair and accurate when compared to cash accounting. So what does accrual mean? The term comes from how revenues and expenses are recognized. This basis of this type of accounting documents revenue and expenses when they accrue or occur, even if there has been no money collected. For example, if a business purchases a piece of equipment, regardless of whether it is with cash or on account, there is an expense that is recorded. On the other hand, if they sell inventory on account, or receive cash, there is revenue recorded. Although this method will not give an accurate statement of a current company’s cash situation, it will give an accurate representation of the businesses profit standing.
The opposite of accrual basis accounting is cash basis. This method recognizes revenue and expenses when they are either paid or received. For example, a business will not show profit on an item sold until they actually receive payment from the client. Likewise, they will not record an expense, or a drop in cash until they actually pay the bill. As one can tell, this can present major problems when it comes to preparing the financial statements. Take for instance a company that for the current period has more outstanding payables than they do receivables.
If they happen to collect they majority of their receivables and do not pay their outstanding bills, it looks like they are much more profitable than they really are. In the following period, when they finally pay off their expense account, it will look like the company took a huge loss, especially if they do not collect enough cash to balance out what they have paid. Based on these examples it is very easy to see how the cash basis can distort a profit and loss statement and could easily confuse investors or other stakeholders.
This article has shown the basics of the two main types of accounting methods. Although each present different ways of recording revenues and expenses, the accrual method has been proven to be more accurate when compared to cash. The accrual method gives any business manager a much better picture of whether the company is making a profit, and can much easily be compared to current expenses.