Examples of Cash vs. Accrual Basis Accounting

There are two primary types of accounting available to businesses -- the cash method and the accrual method. A business or an individual may use one method for internal purposes and one method for tax reporting. Many businesses and professionals are required by law to use the accrual method, although it is permissible to keep duplicate records using the cash method.

Using the cash method of accounting, record income and expenditures according to actual cash flow. For example, if you bill a customer in May but don't receive payment until July, you don't record it as income until July. Likewise, you don't record an expenditure until the money actually leaves your hand or your bank account.

Using the accrual method of accounting, record income and expenditures when the obligations are incurred rather than when cash changes hands. For example, if you sign a purchase contract that obligates you to pay for an item within 30 days, you record it as an expense on the day you sign the contract. It can be difficult in some cases to determine the exact transaction date. If you hire someone to perform a service that will take time to perform, such as constructing a building, it is usually best to record the expenditure on the date the job is completed, unless you paid in advance.

The primary advantage of the cash method is that it takes into account customers who don't pay their bills on time. The primary disadvantage is that it presents a distorted picture of your company's actual financial health -- your business may be declining, but it may look good from an accounting perspective if you are still receiving income from services you performed months ago. The primary advantage of the accrual method is that it presents a relatively accurate picture of your company's financial health. Its primary disadvantage is that it makes it more difficult to determine how much cash you have available.

Your tax burden is partly dependent of when income and expenditures occur. For example, receipt of $1,000 at the end of the current tax year instead of the beginning of the next tax year might kick you into a higher tax bracket and increase your tax burden by more than $1,000. Likewise, incurring an expenditure next year instead of this year might prevent you from writing it off, if the IRS only allows you to write off only expenditures that exceed minimum threshold. In light of this, the accrual method is generally more advantageous, because you have more control over when you bill customers than when they actually pay you.