When do I recognize income? Is a common question that business owners have. Most people would just assume that you recognize all transactions the moment they happen. However it isn’t always that simple. This is because most larger business don’t pay their vendors at the time of purchase. Instead payments can be made weeks or even months after the original transaction. This delay in payment creates a dilemma. Should the vendor recognize the payment at the purchase date. Or maybe should they set up an accounts receivable transaction. This is the basis for accrual accounting.
What are accrual basis and cash basis of accounting?
There are many ways to recognize income. From the straight forward sales basis method, to the much less clear cost recovery method. However there are only two methods for the basis of accounting for a business. These are cash basis and the accrual basis. The first and probably most common is cash basis of accounting. This method is mainly used by small businesses and sole proprietors. This is because it is quite simple to understand. You only recognize things like sales, expenses when you actual get or give the money. An example of this would be paying a landscaper after the job has been done. As soon as they receive the money they record an entry for the sale. This entry would look like a debit to cash and a credit to revenue for the cost of the service.
Accrual accounting is a little bit more complicated. If cash basis is for small businesses then accrual is for medium and large companies. In this method of accounting sales are recognized when the service is performed, or when the payment is agreed upon. In our previous example, if you told the landscaper that you would pay them two weeks time, and that landscaper was on an accrual basis of accounting, then he would still recognize the income for the service. However, the entry would switch just a bit with accounts receivable being debited and sales still being credited. In this method of accounting transactions performed but not paid for are represented by payables and receivables on the balance sheet.
Which Accounting Method is best for me?
Well it depends how big your business is and how accurate you want the information to be. The cash basis method is better for smaller business that value simplicity over accuracy, and for sole proprietors who want to handle their books themselves. Accrual accounting is better for larger companies that need more accurate financial statements. This isn’t saying that cash basis is inaccurate, just that accrual is more accurate than cash basis accounting . If you’re going to get a loan from a bank or if you are going to need to have accrual based financial statements. Accrual based accounting will have accounts payables and accounts receivables to account for transactions that have been completed but not paid for.
Conclusion:
So when you recognize income? Well, it depends which method of accounting you are using. If you using the cash basis of accounting, you recognize transactions when cash is exchanged. If you are using the accrual basis of accounting you recognize the transactions when the service, is done, or the sale is made. Deciding which basis of accounting to use can be confusing and a qualified accountant can help.