I hate the buzzwords and general environment related to accounting and financial terms. No wonder business owners shy away from it. “Accrual accounting” sounds like something you do with thumb screws, rack, and chains. But – damn – it matters. If you run a business, you have huge incentive to understand this stuff.
And there is some good news in this area. At least it’s easy to understand, once you get over the sound of it. Give me just five minutes to read this blog post, and you’ll get it. I hope.
It turns out that all business bookkeeping is going to be either cash basis or accrual. Those are the rules. Too bad “cash basis” sounds so simple and attractive, because accrual is way better, and easier to manage too. Cash basis accounting only works right if you absolutely always pay immediately for every business purchase, and you never buy something before you sell it, and all of your customers pay you in full whenever they buy something from you. That case is extremely rare.
In cash basis accounting, if you sell goods and don’t get paid immediately, the sale doesn’t show up on the books. Sure, there was a sale, and now somebody owes you money. But cash basis bookkeeping ignores it. That sale gets into your books only later, when you get paid. The money your customer owes you doesn’t show up. You keep track of it in a shoebox, or maybe in your head.
In cash basis accounting, when you order some goods, nothing happens. Sure, you now have an obligation to pay; you’ve agreed to spend some money. But it’s not in your books. When the goods come, if you don’t pay for them in cash when they arrive, nothing happens. Yes, you have a debt at that point, but it doesn’t go into your books until you pay it. You keep track of it in a shoebox, or maybe in your head.
In accrual accounting, when you make a business-to-business sale on account, you record the accrued amount as Accounts Receivable (definition), so you keep track of the amount, the date, and the customer who owes it to you. It’s obvious that unless you never sell without immediate payment, accrual basis is better.
In accrual accounting, when you receive the goods you ordered, but you don’t pay for them immediately, you still owe that money. You have an invoice to pay. You record the accrued amount as Accounts Payable (definition), along with the date, a record of what you bought, and who and when you are supposed to pay.
I’m so sorry that the accounting standards that were set a few generations ago chose to call it “cash basis” when you don’t record money owed into your books until it’s paid; or money you owe until you pay it. It’s a terrible idea to keep that information in your head instead of in your bookkeeping. That causes many mistakes as we business owners fail to keep track and remind ourselves of these outstanding obligations. And yet, ironically, they call that “cash basis” accounting. I do wish that the right way to do it, which is accrual accounting, didn’t have such an off-putting name.