Most businesses use one of two accounting methods to keep track of their transactions. These accounting methods consist of rules that are used to determine when and how revenues and expenses are reported.
With the accrual basis of accounting, used by all publicly traded companies and most large businesses, revenues are recorded when they are earned and expenses are recorded when they are incurred. With the cash basis of accounting, used primarily by smaller businesses, revenues are recorded when they are received and expenses are recorded when they are paid. Individuals generally use cash basis accounting when they file their income tax returns.
Some important differences between these two methods are:
- There are no receivables or payables in a cash basis balance sheet.
- For small businesses that are within certain income tax limits, there may not be inventory on a cash basis balance sheet.
- Only the cash amounts that are collected from sales and other revenue activities are shown as revenue in cash basis reports. On accrual basis reports, revenue includes both collected and uncollected amounts.
- Only the cash paid to vendors and others are shown as expenses in cash basis reports, whereas on accrual basis reports, expenses include both paid and unpaid amounts.
The following are examples that use an accrual basis system:
- Revenue is recognized before cash is received and is described as accrued revenue. It is categorized as a current asset. The most common example is accounts receivables that result from sales to customers.
- Cash is received before the revenue is earned and is described as deferred revenue. It is categorized as a current liability. For example, a customer might pay you a deposit for a service. However, you do not recognize the revenue until you have performed the service. Another example might be prepaid rental income. A tenant might pay you on a quarterly basis for rent, but you only recognize each month’s rent as it occurs.
- Expense is recognized before cash is paid and is described as accrued expense. The most common example is accounts payables that result from purchases from vendors. Another example would be paying interest on a bank loan on a quarterly basis but recording the accrued interest on a monthly basis.
- Cash is paid before the expense is incurred and is described as deferred or prepaid expense. It is categorized as a current asset. For example, you might pay your auto insurance every six months, but you only recognize one month of expense at a time.
When you open reports in Microsoft Office Accounting 2008, the reports display, by default, either a cash basis view or an accrual basis view, depending on what you selected in the Preferences section of Company Setup. To change your selection, on the Company menu, click Preferences to open the Preferences dialog box.
Cash discounts that you offer your customers and the write off of uncollectible customer amounts both represent a reduction in the cash to be collected from sales. Similarly, the discounts you take when paying vendors represent a reduction in the cash paid on purchases. The reporting of these items in sales and income tax returns is different from state to state. The Office Accounting 2008 cash basis reports display these amounts so you can properly report them on your tax return if your state or other tax agency permits these items to be deductions.