| Entrepreneurs starting new businesses are often confronted with the accounting question of whether they intend to use the cash or accrual basis. While not exactly Greek, it can seem like a mystery question for those new to accounting or even bookkeeping. You have to know the answer to give to your CPA or in setting up your books yourself. For example, if you are getting ready to use QuickBooks, one of the first questions you will be asked is which accounting method you will use and then the program will help you set up your books accordingly. On IRS business tax forms, you will also be asked this question.
Most small businesses start out with cash basis accounting because it is the simplest, easiest and has the greatest familiarity to someone new to accounting. In its most basic form, it is the same method you use for a checking account. You enter deposits when you receive them and subtract checks as you write them. For a business you will categorize the deposits as to customers or other income while the checks need to be categorized as to what the check is for. Many of us may already use the memo line printed on our checks to specify what the check was for such as rent, utilities, Internet Access, etc.
Because all accounting is current and based on actual cash transactions, you always know exactly how much money is available at any given time. Decisions can be made quickly on money available for expenditures, upcoming bills and other expenses. P&L (profit and loss) statements are based on current costs and assets. That is the big advantage of cash basis accounting.
The accrual method is standard in larger companies and is considered to be the standard for midsized to large corporations.
Although there are many differences the major difference from the cash method is that the receivable from a sale is counted from the date of invoice not from the date received. The concept is that it allows better for long range planning. If you use accrual and someone doesn't pay you, you can deduct the loss from your taxes because your books treated it as income from date of invoice. In the cash method you have no deduction because the books never reflected an income.
Unless properly handled and understood, the accrual method can give a very false sense of security and lead a company to make investments only to find they can't pay for them. This issue became a nightmare that helped fuel the telecom crash several years ago. There was a new development in the telecom industry that was determined to be cutting edge and that would transform the industry. The big names put together their new programs and services plus equipment but could generate little interest. After all the investment in development, the companies decided to take what they considered a low risk approach as they were so convinced of the superiority of the new technology. The offered their big customers free installation and use of the new products free for a year to convince them and then they would pay for the products. To customer companies it was a great deal and many took advantage of the offer. To the telecom companies which were already falling on some hard times, it allowed them to enter the "loaners" as sales in their books. The disaster came when at the end of the year, most clients were not interested in keeping or paying for the products. They had seen insufficient improvement that would justify the expenditure. All of a sudden the losses became a disaster because they had depended on that ultimate income. Some telecoms went under and many major ones had massive layoffs and downsizing.
By using the accrual method, one can easily see the relationship of expenses to the expected income and whether the account is within budget and make adjustments accordingly if needed.
Many companies, particularly small to mid-sized using the accrual method aren't faced with that type of problem because their receivables are not 1 year away; more commonly they are 30 to 60 days away. However, there is always the danger of assumption that the amount the books say is there really isn't. This is a common problem with those used to thinking of books as if they actually reflected the cash on hand. Many mistakes are made that way.
If your bookkeeper, CPA or accounting manager insists that you need to use the accrual method that doesn't mean you can't keep two sets of books. No, I don't mean one set of "cooked books" for investors, the government or taxing authorities and the real books for your benefit. I've actually known people who did that but they always get caught.
Instead, the second set can be done by the cash method so you can have an immediate and current overview of your assets and your costs. It is not illegal to have both kinds of books and in fact it is not an uncommon practice. Both can give you useful and comprehensive views of your company from different perspectives which can be useful in future planning. It might be more time consuming to keep both sets of books but when you might need an immediate answer, it can be well worth the extra work.
One thing you must know is that you can always switch from a cash basis to an accrual method but you can't switch from an accrual to a cash basis.
Whichever method you choose at the beginning it is still best to follow the Generally Accepted Accounting Principles (GAAP) for your books. Although it is only required of public companies and some private companies to be in compliance with the principles, it is always easiest to start out being in compliance than to try to become compliant later on. Read more about GAAP at http://www.fasab.gov/accepted.html.