One of the main goals of accounting is to be able to fairly measure the value of a business at any given point in time. Bookkeepers can use a check book to keep track of all the bills they pay and any deposits they receive.
Accountants, on the other hand, need to know more than just what checks have been written. They have to know what the company is responsible for paying, even if they haven’t cut the checks yet. So, a system was developed for tracking everything, even stuff that hasn’t been paid for. This system is called accrual accounting
Cash Based Accounting
A cash system is what most individuals use. Deposits are recorded in the checkbook when the money is received. Checks are recorded when they are written.
If things are properly recorded, a person can look at the checkbook at any time and know how much cash they have. This is usually good enough for most people, but not for large businesses.
Accrual Accounting Systems
Accrual accounting looks at more than just the cash position, and attempts to determine where the business would be if everything that was owed had been paid as of a particular date. Most businesses of any size use accrual accounting.
The technical terminology is that revenues and expenses should be recorded in the period that they are incurred (not necessarily when they are paid.)
Example of Accrual Accounting
Let’s use the example of buying furniture:
In a cash accounting system, if you buy a couch and have it delivered in January, but the bill is due in February, you record the amount in your checkbook in February.
In an accrual system, the accountant would record the expense for the couch in January, even if they paid the bill in February. Why? Because it doesn’t matter when the bill is paid. The company knows they owe the money in January. So that’s when they book it.
Individuals can get away with using cash basis because they usually keep track of how much they have spent each month fairly easily. Businesses need to have a good handle how much they owe for things that haven’t been paid yet. Accountants work each month to make sure they record all the revenue and expense each month on an accrual basis.