Accounting is an essential step to running a business. Regardless of industry, all businesses need to keep track of their expenses and revenue so that they can optimize their operations for higher profits and pay the correct amount of taxes. But there are different types of accounting from which business owners can choose, the two most common of which include accrual and cash basis.
How Cash Basis Accounting Works
With cash basis accounting, a business records revenue from the sale of a service or product when it receives payment from the customer. Whether the customer pays using cash, credit card, debit card or check, the business doesn’t record the payment as revenue until it has received the funds from the customer. Some basis exclusively use cash basis accounting. Retail stores, for example, typically use this method because they exchange products for money at the same time.
Cash basis accounting offers certain benefits, such as simplicity. It’s easy for businesses to record revenue when they receive payment from the customer. Furthermore, there’s no need to worry about accounts receivables affecting a business’s books. With cash basis accounting, accounts receivables — unpaid invoices — aren’t recorded as revenue.
How Accrual Accounting Works
Accrual accounting takes a different approach. Rather than recording revenue when a business receives payment from a customer, accrual accounting requires businesses to record revenue when a customer makes a purchase. This may sound confusing, but think of it like this: Purchasing and paying for a product or service are two separate things. You can purchase dinner at a restaurant, for example, and you won’t be required to pay for it until after your meal.
Many businesses allow customers to pay for their products or services after purchasing them. With accrual accounting, businesses record revenue when a customer makes a purchase. Customers may pay for their product or service when they initially purchase them. In other cases, customers may wait and pay at a later date, assuming it’s allowed by the business. Accrual accounting ignores the reception of payment from a customer. Instead, it revolves around recording revenue when a customer purchases or orders a product or service
Accrual accounting is the preferred method among business owners, primarily because it views accounts receivables as assets — which they are. On the other hand, however, it isn’t an effective accounting method for measuring a business’s cash flow.
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