Accounting Part 2: Cash Basis versus Accrual Basis
Previously we presented the two main Financial Statements that everyone in the business world should understand. These would be the balance sheet (statement of assets, liabilities and net worth at any given point in time ) and the income statement (measurement of sales and expenses for a given period of time ). But how do we determine when and how we record financial transactions (sales, purchases, loans etc.) to our financial statements? In other words, now what?
The point to recording transactions is to understand how the business is performing. You are making considerable effort to run your business or understand how the company that employs you is faring. What you have to understand is that every transaction or event is recordable. Borrowing money is recordable. Buying inventory is recordable. Selling a product is recordable. Anything defined as an economic event is recordable. I define this as any activity involving the exchange of goods and services between two parties; this may be simplistic but this is a simple course.
In order to understand a set of financial statements you need to know how they record their transactions. There are two types of ways to record transactions: the cash method (known as Cash Basis Accounting) or the accrual method (known as Accrual Basis Accounting). So what is the difference?
The cash basis method involves only recording transactions that hit your check book. In other words, you only record an entry when you give someone cash or write a check or vice-versa. By doing this your financial records should tie precisely to your checkbook. Every entry in your checkbook including charges automatically deducted by your bank or creditors is recorded into your financial statements.
The accrual method involves recording all transactions recorded under the cash basis method PLUS transactions that have not yet involved your checkbook such as buying something on credit. In this way, a set of financials include ALL transactions within a given period of time thereby providing the user or reader of the financial statements a more comprehensive view of the business. Companies that are required to provide audited financial statements (financial reviewed by independent auditors or 3rd parties) use the accrual method because this reveals the activities of a company beyond the checkbook.
By knowing the type of accounting method used, the reader of the financial statements is informed about what it is they are reading. In other words you now have been provided the context of time (what period of time is being measured) and completeness (limited by cash method or fully complete by the accrual method).
Part Three (Account Classification) will discuss the type of accounts that are typically included in the balance sheet and the income statement. Then we can discuss something called the general ledger (and chart of accounts) along with the two-sided entry method of accounting that gives everyone heartburn.