Why is understanding accrual and cash accounting methods important for business owners, particularly for owners of small businesses? Many small businesses are used to using a 'cash in cash out' form of accounting, very similar to the format of bank statement, so why should they consider anything different.
It's all got to do with knowing how well your business is doing month in month out, and just about how much spare cash you have in the bank at any one time. In order to operate a business properly, it is important that you can compare each month on an equal footing. This is an important factor in analyzing whether you are improving during the course of the year or whether you need to take some action to improve the way your business is operating.
Problems with Cash Accounting
You can do that by checking your bank balance! That's where understanding accrual and cash accounting methods becomes important. With a cash system, every time you get paid by a client or customer you mark it as a credit, and every time you make a payment to your workforce or for raw materials you mark it as a debit. Money in - money out; it seems a simple way to keep your accounts, and so it might be - as long as you have no extraordinary expenditure in any month.
How about if you offer credit, as most businesses do? You might incur the expenses for the work or the product one month and not get fully paid for another few months. How about your annual business insurance: will you pay all that in one month and maybe end up making a loss that month because of your cash accounting system.
If your business was doing well and wanted to expand, you might ask the bank for a loan. To get that, they will likely ask to see your profit and loss statement. How would it look if you were making big losses some months because of your cash accounting methods? That where accrual accounting steps in and resolves the problem.
Accrual and Cash Accounting - Accounts Receivable Ledgers
Let's look at understanding accrual and cash accounting methods using the two examples above - first the credit agreement. Let's say you sell TVs. A customer buys a $5,000 TV on credit, paying over 10 months. With the cash accounting system, you would enter the cost of the TV to you as a debit, and nothing as a credit. So you lose in that month, and then gain in each of the next 10 months.
That might be OK to you, because that's how you get your cash. However, the bank won't like it, and in any case, you would find it difficult to analyze the financial condition of your business with these various unmatched payments appearing everywhere in your accounts. Enter accrual accounting.
By understanding accrual and cash accounting methods, you will book the sale and the payment in on the same date. The amount due to be paid by the customer is booked into an account known as "accounts receivable", and appears on your monthly profit and loss statement as a current asset along with the expense - everything balances.
You may pay more tax this way, but you have to balance that against the advantages of accrual accounting - particularly if you are seeking to finance your business.
Prepaid Insurance AccountsThe same is true of an annual insurance premium. You can accrue that by entering the payment into a 'Prepaid Insurance' account which is also regarded as an asset, and you can reduce that by one monthly premium each week, and it to your insurance expense account.
In each of these ways, expense and payment occur in the same months and your financial accounts will balance and please the bank. Understanding accrual and cash accounting methods is just one way of improving your ability to assess the financial health of your business, and to generate meaningful accounts and financial statements.
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