While many people have heard the terms cash accounting in the accrual method, some may not be aware of the exact differences between the two. In this post, we will examine each along with their relative advantages and disadvantages.
Either accounting system looks at activity for a specific period of time. Typical periods include month end, year to date and year end. Each of these is a way to measure how your company is performing. Both systems look at the same activities in a slightly different way. The three types of activities we will look at are the accounting for the sale or revenue collected, the accounting for the cost involved (both cost of goods sold as well as overhead expense to support that sale) and the resultant net profit. Let’s look at the cash method of accounting first.Under the cash method of accounting, a sale is booked when you collect the revenue from it. Therefore, if you ran a service call in July but were not paid for it until August, you would account for that revenue in the month of August on your books. When we look at the cost of performing that call, there are two aspects involved. The first is the direct cost which can be directly attributable to a specific customer or sale. This is called the cost of goods sold. For example, if we send a service tech Billy out to Mrs. Smith’s house to run a service call on July 12, we will account for the cost of the service techs time in the month of July – even though we may not have been paid for that service call until August. The second aspect of cost is called overhead. Overhead represents costs which are incurred to support sales but which cannot be attributed directly to any one sale. For example, the cost of rent for the building that we are using for our business is required for all the business we conduct, and therefore would not be attributable to any one specific customer. In the case of the service call for Mrs. Smith, overhead to support the cost of her July 12 overhead would likely have been paid in July and would have been accounted for accordingly. Net profit for the service call would not be recorded until we had received payment for the call, which would have been in August – so that’s when it would be accounted for in this case.
So how does the cash method differ from the accrual method? The accrual method accounts for revenue, all costs and net profit when the expense occurs. Therefore in the above example of a July 12 service call, all activity would be recorded during the month of July. Based on this, you can see where the accrual method will paint a more accurate financial picture of the activities of your business, but the sales method of accounting is less complex. Which is better for your business? That is best left up to a discussion between you and your accountant or financial professional.
Courtesy HVAC Business Doctor