Introduction to How to Keep Score in Business: Accounting and Financial Analysis for the Non-Accountant, 2nd Edition
- Jan 12, 2012
The Accrual Method
It is time to turn to a diabolical accounting invention—the accrual method.
Individuals keep track of cash. In fact, the IRS directs individuals to keep track of their cash expenditures and cash revenues for tax purposes. This means you don't have any revenue until you have cash in hand (or could have it). Just because someone owes you the money doesn't mean you have any revenue.
The same thing goes for your personal expenditures. If you want to take a deduction for a medical expense on your tax return, you actually have to pay the bill with a check or currency. Just because you visited the doctor and he sent you a bill is not enough to get you a tax deduction. Cash has to change hands.
None of this is true in business. In business, we use the accrual method of accounting, not the cash method.
If you used the accrual method, you would record your revenue whenever it was first owed to you, not when it was paid. You would record your expenditure when you got the doctor's bill, not when you paid it.
The business world offers similar examples of the accrual method. A sales transaction is recorded when the company makes up an invoice for the sale. The dollars are recorded on the financial reports at that time, even though the customer may actually pay days or weeks or months later—or never.
The same thing happens in reverse when a company buys something. As soon as the company gets the invoice for the goods or services it is buying, the cost is recorded in the company's financial records. The dollars involved in the purchase will show on financial reports, even though the company may not pay those dollars for 30 or 300 days.
These are examples of the workings of the accrual system. Transactions enter the financial records as soon as they take place, not when the cash involved with the transaction changes hands. It is quite possible for a company to report big profits and be broke—unable to come up with enough cash to buy a cup of coffee. Conversely, a company may show a loss on its financial reports even though it put cash in the bank.
The accrual method of business accounting guarantees that financial reports show scores, not real, spendable dollars.