With limited staff and resources, it’s important that startups understand basic accounting functions to keep their company in a good place financially. Knowing the two methods of accounting that can be used to record transactions is a great place to start. The main difference between the cash basis and accrual basis method of accounting is the timing of the transactions being recorded and when revenue and expenses are recognized. Below, we’ll walk through a list of common questions to help understand this method of accounting and how it works for startups.
When are income and expenses recognized?
Cash Basis- At the time cash is received or expended. It’s important to note that “cash” includes all cash equivalents including checks, credit card payments, etc
Accrual basis- Recognized at the time revenue and expenses are incurred. The accrual method keeps track of all amounts due in a payables account, and all incoming money owed by customers in a receivable account.
When are income and expenses “incurred” for the accrual basis?
Income– Recorded when the goods or services have been provided.
- Example for goods: If a company enters into an agreement to supply a customer with 100 t-shirts, the income from this transaction won’t be recorded until all 100 of those t-shirts are provided to the customer.
- Example for services: After services have been completed, the company would prepare an invoice to the customer. Once the invoice is created, income is recorded, see below for the journal entries, regardless of when the customer actually pays the invoice.
Expenses– Recorded when goods have been received or services have been completed.
- Example for goods: When a company purchases office supplies, they will record the office supplies expense when those supplies are received.
- Example for services: A company who pays for work to be done on their office space won’t record the expense for those services until all of the work is complete.
Stay tuned for our upcoming blog post on Deferred Income and Expenses to see how to record transactions where cash has been exchanged, but the income or expense is not ready to be recognized because the goods or services have not been provided.
What are the journal entries for recording income and expenses under the cash method?
Journal entry for income:
Debit: Cash
Credit: Revenue Account
Journal entry for expenses:
Debit: Expense Account
Credit: Cash
What are the journal entries for recording income and expenses under the accrual method?
Income: Journal entry to record an invoice to a customer after the goods or services are complete:
Debit: Accounts Receivable
Credit: Revenue Account
When the customer pays the invoice and the cash is received they would then make the following journal entry:
Debit: Cash
Credit: Accounts Receivable
Expenses: Journal entry for when goods have been received or services have been completed:
Debit: Expense Account
Credit: Accounts Payable
When cash is used to pay for the goods or services received on credit, the following journal entry would then be made:
Debit: Accounts Payable
Credit: Cash
Which accounting method is better?
One is not necessarily better than the other, it depends on the business. A tax or accounting professional can help you find the best fit for your specific business.
As demonstrated, the cash basis method depends solely on when cash is received or expended. Whereas the accrual basis method depends on when the revenue and expenses are incurred, regardless of the timing of the cash flows. This often makes the cash basis method simpler to implement and gives the company a better look at their cash flows; however, the accrual basis method generally gives the company a better understanding of their company’s financial position and how well they’re actually performing.
For more accounting how-to’s, check out our other Accounting 101 blog posts on Chart of Accounts and Double Entry Accounting. If you have any questions about which accounting method you should use, please contact an Anders Advisor.
