Guide to Cash or Accrual Accounting

How to decide which accounting method best fits your needs
By Kay Bell

Cash-based accounting recognizes income when the money is received. Accrual-based accounting recognizes income when goods are shipped or services rendered. For expenses, under the cash method, an expense is recognized when you pay it. Under the accrual method, the cost is recognized when your company is obligated to pay it.

For accounting purposes, most businesses opt for the accrual method. Cash-based accounting can distort the true operations of your business and incorrectly reflect income. The choice generally is yours, although in certain circumstances the IRS requires companies to use the accrual method. And some businesses decide to use a hybrid of the two.

In determining which accounting system to use for your business, you should:

1.                           Understand the requirements of each method

2.                           Examine accounting software

3.                           Consider hiring a professional bookkeeper

Action Steps

The best contacts and resources to help you get it done

Accounting 101 Basically, the two accounting methods differ only in the timing of when transactions are credited or debited. In practice, though, accounting is rarely basic.

I recommend:  You can find good primers on the accounting methods at Nolo.com, Business Owner"s Toolkit, Inc.com and American Express. You can print out a PDF version of this guide to cash vs. accrual accounting provided by Texas A&M University to read at your leisure.

Computerize the process Unless you"re running a micro-business, you probably have your accounts on computer. But does your current software meet your accounting needs? And will it allow you to change as your business grows?

I recommend:  Top Ten Reviews looks at the pluses and minuses of, you guessed it, ten business accounting programs. The Logos accounting program also provides a side-by-side look at some factors to consider in deciding whether to use the cash or accrual method.

Hand over the books Regardless of whether you choose the accrual or cash accounting method, you"ll probably find that hiring an accountant to keep track of the numbers is a worthwhile expense.

I recommend:  Gaebler Ventures and is4profit each offer tips on how to hire a business accountant. The first recommendation is to ask for local referrals. But you also can find business accountants via the practitioner search engines at Accountants World, GoodAccountants and the National Society of Accountants.

Tips & Tactics

Helpful advice for making the most of this Guide

·                 Make sure you understand the financial and tax implications of the accounting method you choose.

·                 When considering a computer accounting solution, look for one that supports your entire company — sales, service, accounting — so that you can integrate all your financial applications.

·                 Make sure the accountant you choose is a business accountant. The needs of individuals are much different than those of a business.

·                 In that same vein, look for an accountant who knows the needs of your particular industry.

The "Big Four" accountancy firms

The "Big Four auditors" are the largest multinational accountancy firms.

• PricewaterhouseCoopers
• KPMG
• Deloitte Touche Tohmatsu
• Ernst & Young

These firms are associations of the partnerships in each country rather than having the classical structure of holding company and subsidiaries, but each has an international "umbrella" organization for coordination (technically known as a Swiss Verein).

Before the Enron and other accounting scandals in the United States, there were five large firms and were called the Big Five: Arthur Andersen, PricewaterhouseCoopers, KPMG, Deloitte Touche Tohmatsu and Ernst & Young.

On June 15, 2002, Arthur Andersen was convicted of obstruction of justice for shredding documents related to its audit of Enron. Nancy Temple (Andersen Legal Dept.) and David Duncan (Lead Partner for the Enron account) were cited as the responsible managers in this scandal as they had given the order to shred relevant documents. Since the U.S. Securities and Exchange Commission does not allow convicted felons to audit public companies, the firm agreed to surrender its licenses and its right to practice before the SEC on August 31, 2002. A plurality of Arthur Andersen joined KPMG in the US and Deloitte & Touche outside of the US. Historically, there had also been groupings referred to as the "Big Six" (Arthur Andersen, plus Coopers & Lybrand before its merger with Price Waterhouse) and the "Big Eight" (Ernst and Young prior to their merger were Ernst & Whinney and Arthur Young and Deloitte & Touche was formed by the merger of Deloitte, Haskins and Sells with the firm Touche Ross).

Enron turned out to be only the first of a series of accounting scandals that enveloped the accounting industry in 2002.

This is likely to have far-reaching consequences for the U.S. accounting industry. Application of International Accounting Standards originating in International Accounting Standards Board headquartered in London and bearing more resemblance to UK than current US practices is often advocated by those who note the relative stability of the UK accounting system (which reformed itself after scandals in the late 1980s and early 1990s). Accounting reform of a far more comprehensive sort is advocated by those who see issues with capitalism or economics, and seek ecological or social accountability.

Accounting Standards

In order that financial statements report financial performance fairly and consistently, they are prepared according to widely accepted accounting standards. These standards are referred to as Generally Accepted Accounting Principles, or simply GAAP. Generally Accepted Accounting Principles are those that have "substantial authoritative support".
Accrual vs. Cash Method

Many small businesses utilize an accounting system that recognizes revenue and expenses on a cash basis, meaning that neither revenue nor expenses are recognized until the cash associated with them actually is received. Most larger businesses, however, use the accrual method.

Under the accrual method, revenues and expenses are recorded according to when they are earned and incurred, not necessarily when the cash is received or paid. For example, under the accrual method revenue is recognized when customers are invoiced, regardless of when payment is received. Similarly, an expense is recognized when the bill is received, not when payment is made.

Under accrual accounting, even though employees may be paid in the next accounting period for work performed near the end of the present accounting period, the expense still is recorded in the current period since the current period is when the expense was incurred.

Introduction

The purpose of accounting is to provide the information that is needed for sound economic decision making. The main purpose of financial accounting is to prepare financial reports that provide information about a firm"s performance to external parties such as investors, creditors, and tax authorities. Managerial accounting contrasts with financial accounting in that managerial accounting is for internal decision making and does not have to follow any rules issued by standard-setting bodies. Financial accounting, on the other hand, is performed according to Generally Accepted Accounting Principles (GAAP) guidelines.
CPA"s

The primary accounting professional association in the U.S. is the American Institute of Certified Public Accountants (AICPA). The AICPA prepares the Uniform CPA Examination, which must be completed in order to become a certified public accountant. To be eligible to become a CPA, one needs an undergraduate degree in any major with 150 credit hours of course work. Of these 150 credit hours, a minimum of 36 credit hours mustz be in accounting. Only about 10% of those taking the CPA exam pass it the first time.