Cash vs Accrual

Although cash-basis accounting provides a simplistic approach, it may misrepresent the company’s actual financial position.  Bills that have been received this month but not yet paid would not show up as expenses, even though the company has incurred those costs.  Similarly, revenue that was earned this month would not show up on the financial statements until the customer paid.

Because of these weaknesses, accrual accounting is built on the framework of complete transparency to match revenue and expenses to the period incurred. Accrual accounting reports income when earned vs. received and expenses when incurred; not necessarily when paid.

Looking at the accrual method from a high-level perspective, it uses standard accounts such as; cash, equity, income, and cost of goods sold (COGS) in its configuration. With the accrual method, you must record income when you have earned it and record expenses when services were rendered (or products were shipped). Even if there hasn’t been a transfer of money, it still needs to be accounted for on that exact date, making this method slightly more complex to track compared to cash basis accounting.

This is why it’s imperative that if you stay the course with accrual accounting that you keep track of any money that you owe and owed to you down to the dollar and date. For instance, when you pay rent for one year, it is crucial to come up with a monthly adjusting entry to recognize the amortization of this cost across the year. As companies grow, accrual basis is required to report to investors, management, and publicly (for exchange-listed companies).  Implementing accrual accounting early on in a company’s lifecycle helps to avoid significant overhaul later when the company grows and maintains clear and accurate financials starting from inception.