The cash basis of accounting is the method of recording revenue when cash is received and recording expenses when cash has been paid out. This method is easy and enables the business to legally manipulate taxable income. Paying less in taxes is as easy as spending more money.
The cash basis is common for small businesses that are not yet established. However, the Internal Revenue Service requires businesses to use the accrual method for inventories. As a result, some businesses adopt a hybrid basis where they use both the cash basis and the accrual basis. This is referred to as the modified cash basis of accounting.
Because there are so many advantages to using the accrual method, it makes sense to just commit to using the accrual method of accounting. We will explore what the accrual method is and why it makes sense to use it.
What is accrual accounting?
Accrual accounting is a method of accounting that records revenues when they are earned and record expenses when they are incurred, regardless of whether money has changed hands. The goal is to recognize related revenues and expenses in the same period. Accountants refer to this as the matching principle.
A quick example will better illustrate what this means. Your top salesman had a stellar month in January and sold $750,000 worth of merchandise, earning himself a commission of $7,500. Everyone hustled and it shipped by the end of January. The salesman was paid February 1. Under the accrual method the commission expense should be recorded in January, since the commission was for the sale generated in January.
What are the benefits of accrual accounting?
There are four major benefits to accrual accounting. First, the ability to match revenue with the related costs enables you to track profitability and better understand cash flow. As you track profitability, patterns will arise that will enable you to make better decisions.
Second, it provides a more accurate picture of the state of your business than cash-based methods. The accrual method makes it easier to anticipate your expenses and predict sales. Being able to predict and budget are essential skills to be able to anticipate the needs of your business.
Because the accrual method of accounting provides a clearer picture of your business, many banks require financial statements to be prepared accordingly. This makes it easier to obtain credit and expand your business to meet market demands.
Third, it is compliant with Generally Acceptable Accounting Principles (GAAP). GAAP is a collection of accounting standards and industry practice that have been developed over many years. This one is huge because it puts everyone on the same page. Accounting is commonly referred to as the language of business. GAAP ensures that everyone is speaking the same language.
Last, GAAP makes it easy to answer the question “How are we doing?” Because GAAP creates one standard for everyone it makes it easy to compare the current period to past periods.
Even more, you can compare how you are doing to how others in the industry are doing. For example, pretend you are a producer of red wines. You can look up publicly traded wineries like Vintage Wine Estates ($VWE) or Willamette Valley Vineyards ($WVVI), which are both listed on the NASDAQ. Look up their statistics on Yahoo! Finance to get an idea of what how they are performing. Knowing how others in the industry are performing gives you an idea of what your numbers should be.
Creating metrics to gauge your financial performance is a whole other—but exciting—conversation. To show you what is possible, $WVVI, who started publicly trading in 1994 enjoys a 10.28% profit margin. Whereas $VWE, who recently started publicly trading only enjoys a 4.52% profit margin. What does $WVVI know about wine making that $VWE is missing, as illustrated in the stark differences in profit margins?
Accrual Accounting and Protea Financial
Although accrual accounting takes more time because it can be complicated, the advantages outweigh the disadvantages. It enables you to track profitability and better understand cash flow, which provides a more accurate picture of your financial position. In addition to being compliant with GAAP, it also provides useful information for making business decisions about inventory purchases, investment opportunities, and financing needs.
Accrual accounting is more than cash transactions; it provides information about assets, liabilities, and earnings. Accrual accounting provides a better view of your overall financial position. Because the accrual accounting method is consistent with GAAP, the rules to prepare financial reports of both public and private companies are oftentimes a more accurate method for most companies.
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