There are two primary ways to handle accounting in your business: cash-based and accrual-based.
Many businesses who do not have a dedicated accountant tend to default to cash-based accounting. In this type of accounting, income and expenses are recorded when they are received or paid; that means you record income based on when money actually hits your account, and you record expenses based on when money is actually taken from your account.
This is a popular method because it’s more simple and easier to implement than accrual-based accounting, but it doesn’t provide as accurate a picture of your company’s financial performance.
In accrual-based accounting, income and expenses are recorded when they are earned or incurred. This means that income records are based on when work is done, regardless of when payment is received, and expense records are based on when you make a purchase, regardless of when you actually pay.
For example, let’s say you sell a service to someone on a three-month payment plan, where 1/3 of the total cost is due in January, February, and March. In cash-based accounting, you would record each monthly payment in the month the payment is received. In accrual-based accounting, the entire sale would be recorded in your financial statements at the time the sale is made, even though you haven’t been paid in full.
This is considered to provide a more accurate view of your financial performance, because it actually indicates when the money was earned. In cash-based accounting, January, February, and March would all show as having the same amount of income, even if you didn’t make any additional sales the latter two months.
Similarly, let’s say you purchase a new piece of equipment for your business on credit and you will be making monthly payments until it’s paid off. In cash-based accounting, your recurring payments would be recorded in each month they’re made; in accrual-based accounting, the entire total would be recorded in the month you actually made the purchase.