Cash versus accrual accounting: should you log incoming revenue when the cash comes in or when you deliver the service?
Let’s say you have a consulting business, and you do some work for your client in January, and at the end of the month in January you send them an invoice. But your client doesn’t pay you until February–– you know it takes them a couple of weeks to cut the check –– and then in February, you get the check for $500 worth of consulting. Now, do you book the revenue from the consulting services in January, when you did the work? Or do you book the revenue in February, when you got the check from your client?
This right here is the difference between cash accounting and accrual accounting. When do you book the revenue, when the services or goods were delivered, or when the cash was received. If you are doing accrual accounting, then you are going to book the revenue in January when you actually performed the services. If you are doing cash accounting, then you will book the revenue in February when the check was received.
Similarly, you can think about your expenses as cash versus accrual. Let’s say you purchase some office equipment on account in February. Is the expense marked in February, when you purchased the equipment, or is the expense booked in March, when you actually pay for it? If you book it in February when you actually purchase it, that is accrual accounting. If you mark it in March when you pay for it, that is cash accounting. So how do you account for the differences between when you purchase something and when you pay for it, or when you provide services and when you get the cash? There is a lag, and you want to make sure you are tracking these expenses and these revenues even though the cash hasn’t transpired. And that is how we use accounts receivable and accounts payable.
Accounts payable is when you have an expense that you haven’t yet paid for, so you mark the expense on your books and your income statement, and then you have a liability account, accounts payable, of things that you owe. And you have accounts receivable when you provide services or goods to your clients, but don’t have the money yet. It is a way to track what transactions have happened, but cash hasn’t been received yet.
Here are a couple of examples of cash versus accrual accounting. Let’s say you pay for insurance on January 1 for the year. The insurance is good for the entire year, so in essence it is really being accounted for one month at a time. If you are using cash accounting, you are going to mark the expense in January, when you actually pay the bill. If you are using accrual accounting, then you are going to mark the expense one twelfth every month. If you receive a deposit for work in February to be completed in March, with cash accounting you record the revenue in February. With accrual accounting, you are going to record the work in March when the work is completed. If you send the invoice to a client for work completed in March, you will record the revenue when the payment is received under cash accounting, and you will record the revenue when the work is complete under accrual accounting.