Not all accounting takes place in the same way. While there are general rules that companies and certain kinds of businesses abide by, it’s important to know all your options as you might potentially benefit from taking on another method depending on how you operate:
Types of Accounting Methods
Cash Accounting
Cash accounting is widely regarded as a simpler method and is the common choice among small businesses and medium-sized enterprises. This method of accounting records transactions only when you spent or received any cash. So, when a business or an individual makes a sale and the payment is received or when they pay for a bill and the expenses are noted down, that’s when the transactions are recorded.
This method is recommended for smaller businesses and personal finance needs, but larger businesses are generally required by financial authorities to opt for the accrual accounting method.
Accrual Accounting
The reason the accrual method is preferred over the cash accounting method is that it provides a clear image of how a company is performing financially. While the cash accounting method accounts for any transactions when the payment is received, the accrual method records them down when they incur. There’s no waiting time for the transfer of cash, which is fairly common for larger businesses as the transactions and dealings take place over a long time due to the size of the transaction.
A similar principle applies for any expenses, which are record as they incur and not when the actual payment has been sent through.
Example
For a smaller business, opting for a cash accounting method makes sense as their transactions are generally smaller. These businesses generally take the payment on the spot or shortly after any booking is made, which makes it convenient for them to record transactions as soon as there’s a transfer of cash. For a larger business, for example, a construction business, the projects are of a larger scale and complete cash payments don’t come in until the end of the project.
If one were to record the transactions under cash accounting rules, until the revenue comes in, the company seems to be in a state of debt or loss, which doesn’t look good on paper for potential investors and other shareholders. To avoid this misrepresentation, companies opt for a percentage of completion methods. Depending on the state of the project, the transactions are recorded accordingly. The actual cash records are noted down in the cash flow statement.
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