As any textbook on accounting methods will tell you, there are two main methods by which companies record their financial transactions in their books. They call one cash-basis accounting, and they call the other accrual accounting.
If anyone asks you what the difference between the two accounting methods is, the most important one is this – they record cash flow differently, as James Smith from James Milne Accounting. explains. The simple differences in the way in which these two accounting methods deal with cash flow can open the way to a lot of manipulation. You’ve heard a lot about Enron and how they cooked their books, haven’t you? A lot of that happened because they try to pull the wool over their auditors eyes do with which one of the, the methods they were using.
A company that uses cash basis accounting, when expenses occur, will record them only when the cash is actually spent. They will only record money coming in when the monies actually come in and it’s sitting at their bank accounts. So if the companies finished a project today but they won’t get paid for it until the following month because they extend credit, they won’t get the records that doesn’t come. If the next month is January and falls in all new year, they only get to recorded as income for the next year. Even if it was earned this year.
Small companies usually use cash basis accounting because it’s much simpler. Usually, startup companies and single-proprietor stores use this method.
Accrual accounting leaves a lot more to the imagination. Whatever they have due to them, they’ll record as income already received. If they do a job for a deadbeat client, they’ll still get to record that as income and not be forced to do anything about it for a good long time. All large companies use this method. For reasons that you can imagine.
It can make a major difference to a companys stated profits which accounting method they choose. In cash basis accounting, everything they spend and everything that comes in nothing is recorded until money actually goes out of the bank or comes in. So if they buy something on credit, it’s like the transaction doesn’t exist as far as cash basis accounting is concerned. But it’s a great way to keep track of actual cash.
In accrual accounting, everything is done as if all promises are always kept. If you buy anything on credit, that’s recorded as an actual expensive even if they don’t pay for it for three months. And if anyone promises to pay, that’s recorded as actual income. Even if it’s a client who never intends to pay.