Knowing these accounting terms is crucial if you are a business owner or a bookkeeper.
New businesses require an accounting basis. This is necessary so that each business can determine its bottom line and comply with various regulations regarding the recording and reporting of income. Essentially, there are only two accounting bases available. They are the cash basis and the accrual basis.
Cash Basis of Accounting
The best analogy for the cash basis of accounting is your personal finances. Generally speaking, you, as an individual, recognize income when you receive cash, think payday, and you recognize expenses when you spend cash, think telephone bill. The same basic concept applies to the cash basis of accounting for businesses. As in all aspects of life, the cash basis of accounting offers its own advantages and disadvantages. One major advantage is that you have a significant amount of control as to when you recognize items of income and expense. For example, you can delay the receipt of cash to a future period or you can accelerate the payment of cash to the current period for expenses not yet, technically, incurred. The corresponding disadvantage is that this poses a problem for your income tax accounting because it can be interpreted to be a form of income manipulation - a practice that is severely frowned upon by the Internal Revenue Service. Additionally, there are other regulations that control whether or not you can adopt the cash basis of accounting.
Accrual Basis of Accounting
To extend the above analogy regarding personal finances, the accrual basis of accounting would apply to you if you recognize an expense as soon as you received a bill and you recognize income as soon as you earned it. That is, however, where the analogy ends. Imagine trying to manage your personal finances in this way - recognizing income as soon as it was earned would become tedious very quickly for the hourly wage earners. For business, the accrual basis of accounting allows for a better matching expenses to revenues. Simply put, the matching principle allows for the tracking of the expenses necessary to generate the associated revenues. For the layperson, the matching principle basically tells you what is working and what is not working. In general, the business' size determines whether the accrual basis of accounting is required.
Regardless of which basis you believe you should use or you want to use, you should always consult with an accountant prior to adopting a given basis. Regulations change and an accountant is in the best position to offer you advice regarding the cash basis of accounting or the accrual basis of accounting.
