Businesses manage their finances using one of two accounting systems: accrual accounting or cash accounting. The primary difference lies in when you "book" your revenue and expenses -- that is, when your business reports on its balance sheet, and on its taxes, that it received money or spent money. Each system has its strengths and weaknesses.
Cash accounting, or cash basis, is the simplest accounting method. It's similar to the way a typical household manages its checkbook. In cash accounting, you book income only when you actually receive money, regardless of when you provided the goods and services that produced the revenue. Similarly, you book your expenses when you actually pay for goods and services, regardless of when your ordered or received whatever it is you're paying for.
In accrual accounting, or accrual basis, you book revenue as soon as you make the deal that will produce the income, regardless of when you expect that money to come in. And you book your expenses as soon as you take on the obligation to pay for something, regardless of when you actually receive it.
Say you own a restaurant, and you need 100 pounds of tomatoes. You call up your produce supplier and place an order for 100 pounds at $1 a pound. If you're using the accrual method of accounting, you'll book that $100 expense as soon as you take on the obligation -- the day you order the tomatoes, or the day they're delivered, depending on your arrangement with the supplier. If you're on a cash basis, you don't book the expense until the bill comes and you pay the $100.
As for income, say someone calls and wants to reserve your restaurant's banquet room for next Friday, which costs $500. On an accrual basis, you would book the $500 as revenue immediately. On a cash basis, you'll have to wait until the customer actually forks over the money for the reservation.
Pros and Cons
Accrual accounting gives a better sense of the pace of your business -- what legal and business advice website Nolo calls the "ebb and flow of business income and debts." If you're doing steady business, or your business is expanding or shrinking, that will show up in the pace of your booked income and expenses. However, accrual accounting can hide cash-flow problems, because your balance sheet will show revenue that hasn't arrived yet. With cash accounting, you always know how much money you have at any given time. But it can give you a distorted view of the state of your business, because a "successful" month isn't necessarily one in which you do a lot of revenue-generating work, but rather one in which you get paid for work already done. Cash accounting can also mask unpaid debts.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.