When an investor or market analyst examines a business to determine whether its stock represents a good investment, one of the key pieces of data is that company's income. However, not all businesses account for income in the same way. Within the standard practices of financial accounting there are two major income accounting methods, known as cash and accrual accounting. Investors need to know which method a business uses before fully understanding its income records and financial statements.
Both accrual and cash income refer to all income that a business receives from transactions such as sales, licenses and interest on investments. However, accountants measure accrual income and cash income differently based on the timing of transactions. Cash income is money, in the form of cash or checks, that a business actually receives, regardless of when it delivered the goods or services that the money is for. Accrual income is money that a business has earned, regardless of whether it has received payment yet.
Deciding when to record a transaction on a business's books marks the difference between cash and accrual accounting. Cash accounting only records income when the business receives it in full. Accrual accounting records income as soon as the business has completed its service or the delivery of goods that entitles it to income in the future. For example, if a business makes three shipments of merchandise to a retailer, it can only record the income using the accrual method once the third shipment arrives at the retailer. This is true even if the buyer has an arrangement to pay for the goods several months in the future.
Selecting a Method
Each business must use one method of income accounting consistently. Most large businesses must use accrual accounting to comply with generally accepted accounting principles (GAAP). This allows investors to compare income data for public companies on a level playing field. Small businesses may elect to use cash accounting for its simplicity, though business leaders and accountants can select whichever method they wish.
Even though cash and accrual accounting deal with the same transactions, they lead to very different end results. According to a study by Dr. Paul Ellinger of the University of Illinois, the annual difference between cash and accrual income for a business can range from 11 percent to 68 percent. This means that even if a business sees a low rate of change between cash and accrual accounting, its year-end finances will look very different to investors and market analysts.
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