Just what do you mean by Accrual Based?

Cash-Based vs. Accrual-Based Accounting

Here's a popular question new business owners ask. What do the terms "cash-based" and "accrual-based" mean in accounting terms, and why is it important?

Cash-based accounting is just like it sounds: you only record income when you are paid for a sale and you only record expenses when you write the checks to pay them.

Cash-based accounting works better for some businesses than other. We see it a lot in service provider businesses, such as doctors, lawyers, or accountants, where you are required to pay for a service at the time it is performed.

Accrual-based accounting is more flexible than cash-based accounting because it allows you to have things like accounts receivable and pre-paid expenses. Accounts receivable is fairly obvious � when you are paid over time for a service or a product, you have an account receivable with the customer or client until the entire amount is paid. In bookkeeping terms, that account receivable is an asset � it represents money you are going to receive.

Expense items are a bit trickier. Let's say you belong to Stamps.com, and purchase $100 of postage for use over time. With cash-based accounting, you would record the entire $100 as an expense to your postage account. But if you were using the accrual-based method instead, you would treat that $100 as an asset, and only expense it as you actually put stamps on letters and sent them out the door. An insurance policy would work the same way. If you had a car you were using for work and were writing off the yearly insurance policy, you would be able to expense out the premium over 12 months, even if you had to pay for the entire 12 months up front.

While accrual-based accounting sounds like it is more work than cash-based accounting, it does have some advantages. For example, cash-based accounting isn�t the most accurate method of tracking business expenses. By not being able to spread out your expenses, you can throw off your financial statements for months where you have big expenses (such as the car insurance premium we discussed above).

Most businesses that sell products and maintain inventory need to be accrual-based. That's because when you buy products for your inventory you can't expense them until the items are sold. Remember, in the accounting world, that inventory sitting on your shelves is always considered an asset until it is sold. Once items are sold, the cost of the items are calculated and deducted from the sale price, to form your net revenue.

And, just when you thought things couldn't get any more interesting, there is also something called a hybrid accounting method.

The hybrid method can be used by any business which carries inventory for resale but that is otherwise a cash basis taxpayer. eBay sellers are an excellent example of this � you don't carry accounts receivable, but you do have shelves of inventory.

With the hybrid method, your sales revenue and cost of goods sold expense are accounted for using the accrual method, whereas your operating expenses are reported on a cash basis.

I think the hybrid method is an excellent way to get the best of both worlds. But if you use this method make sure that you account for all debts owing and not yet paid at the end of your fiscal year. Otherwise, your asset amount will be too high and your expenses will be too low, which may cause you to pay more in taxes than you should be.