Accrual Accounting Method
Cash-basis accounting is the method where the customer does not pay until the invoice comes. The accrual accounting method is the opposite of cash-basis, and it is used by more businesses. A company that would use the accrual accounting method would document revenue when the work or service is completed, not when they receive the cash. The customer may not have even paid the company yet, but they have earned it so they record it. If the company has any expenses, they are handled in the same way. Anything the company needs to buy to get the job done is usually bought on the account and not paid for until the company receives the bill.
The accrual accounting method is much more difficult to implement and maintain than the cash-basis method, but it gives a much more reliable picture of how a company is operating. Expenses and earnings are coordinated, giving the company an idea of how much money they are bringing in each month and how much they are spending.
An example of how these two methods can have completely different financial outcomes, compare a painting company’s use of the cash-basis accounting method and the accrual accounting method: a painting company contracts a customer for a job that will total $2000. The painter expects to get a $500 profit, which means his total expenses for supplies, etc. are going to be $1500. The contract says he is to start work on Dec. 19, 2014 and complete the work on Dec. 31, 2014. The painter agrees to be paid on completion of the work, which means he gets paid the first week in 2015. The painter does not have to report this wage on his 2014 tax report if his company is using the cash-basis method, even though this is when the painter worked on the job. The company does leave the expenses paid on the 2014 tax report. Taxes for this company in 2014 will be much lower. If this same company uses the accrued method to record its business, then the expenses and the payment will be put in the books when they actually incurred, on Dec. 31, 2014. The company’s net income is higher, as are their taxes. Because the customer has not paid at the time the company enters the sale in their books, the amount of cash they have may be ambiguous. If a few customers don’t pay their bills, this company could have huge cash flow problems.