Part 1: Living In A Cash Vs. Accrual World …

It is May 4, and you just bought a new grill – and it is beautiful.  This is not for amateurs – you could cook for an actual army on this thing with the stainless steel racks and the industrial-strength rotisserie.  You went all out this time – to the tune of $2,000. But because of a financing offer, you have 90 days to pay it off. You brought it home that day, and started looking around for something to set on fire.  But first, your spouse comes out and says, “what did you buy?” And you say, “Oh, I didn’t buy anything.” — Nothing happened at all, because I haven’t paid any money yet.

Two months later, on July 4, you host a Block Party and get voted Neighbor of the Year on the strength of your Kansas City-style BBQ ribs.  A friend asks, “When did you buy this grill?” You say, I haven’t yet, and he walks away figuring you’re more strange than he thought.

On the 90th day, August 4, you stroke a check for the $2,000 and post on Facebook, “Today I bought a fancy new grill” with a picture.  That is the “cash basis” of accounting: you only recognize that a transaction has occurred when cash changes hands.

Wait, when did you buy the grill?  May 4 or August 4? If you say May 4, you are engaging in a very basic example of the “accrual basis” of accounting.  That is, you recognize that a transaction occurred at the same time that the economic benefit of the asset (in this case, the enjoyment of using the grill) transferred to you, and that you incurred a debt on that date as well.

The example applies to two ways of recording transactions in your business:

Accrual Method Accounting is simply another way of saying that in business, we are going to record transactions (could be Sales Revenue, or Cost of Goods Sold, or Expenses) when the transaction creates an economic event, not when payments are sent or received.  If, in my business, on August 25 I buy $100 worth of office supplies on 30-day payment terms, how much cash has changed hands? Give yourself a star if you said, “none.”  On September 25, I paid for the supplies.

So, under the Accrual Method, I bought supplies on August 25, but instead of cash going out the door, I have simply incurred a Liability (debt), called Accounts Payable.  In QuickBooks, enter a bill for $100.00 to Supplies Expense and you will see a general journal entry that looks like this:

• DR Supplies Expense  100

• CR Accounts Payable             100

When I later pay the bill (on September 25), Accounts Payable goes away:

• DR Account Payable    100

• CR Cash                                    100

Under the Cash Method Accounting, nothing happened on August 25.  But on September 25, when the bill came and you paid it, you now have a general journal entry that looks like this:

• DR Supplies Expense  100

• CR Cash                                   100

A key benefit of the Accrual method is that it matches up an Expense to when the transaction occurred, yielding a more accurate picture of your financial statements.

A key benefit of the Cash method is that it may help defer some taxes, and can be highly useful in analyzing the ups-and-downs of cash flow.

We will explore the financial statement and tax impacts of the two methods later this month in Part Two!