Accrual versus Cash Method of Accounting

There are two ways to do your accounting. There are powerful justifications for each method. A number of factors must be considered when choosing which is best for you. Your CPA or tax accountant is best consulted for this information. Of course, this goes for everything contained in this book.

Accrual accounting is the process where income and expenses are both recognized in the period (the month or year) they occur. This is the ideal accounting world visualized by professional accountants. The beauty of the Accrual Method of accounting is that it gives a realistic picture of how profitable operations are, month by month. The problem with Accrual accounting is that it can show profits and trigger tax liabilities when no cash has been collected to pay those taxes. Still, Accrual accounting is the preferred method of tracking profitability because it is a powerful management tool.

Cash accounting is the process where incomes is recognized when it is received and expenses are recognized when they are paid. In the real world, we often pay bills and make payrolls far in advance of being paid for our work. When using the Cash Method of accounting, our income statement usually shows an operating loss until we are finally paid. This means we defer or delay paying taxes. The weakness of this method is that it does not give us a true picture of profitability until the job is over. In the real world, we need to know how each job is doing on a daily basis, not when the job is over. We can’t control costs and resulting losses if we don’t know what they are on a timely basis. When we do encounter losses or unexpected expenses as they are happening, we might be able to remedy them. For instance, it may be appropriate to recover unexpected expenses through Change Orders.

Change Orders are amendments to our original construction agreements that reflect a change in what is being built and therefore a change is what is to be billed to the customer. In many cases, Change Orders are the difference between making and losing money. Few jobs are completed that end up exactly the way they were visualized or designed at the beginning. The expression, "While we’re at it . . . " often results in costly changes in what is being done. These costs should be passed along to the customer in the form of Change Orders.

It’s time to pay the $1,000 Invoice we have in Accounts Payable:

Cash went down $1,000 and Accounts Payable did too. Notice that this did not affect the profitability shown in Year-to-Date Earnings. The expense was already accounted for when we debited Material for $1,000. Again, we see that Cash Flow does not necessarily affect Profitability when we are using the Accrual method of accounting.

It’s payday so let’s pay the $1,500 Payroll we accrued for last month:

Cash went down $1,500, the same as Accrued Expenses & Taxes. Again, this transaction did not affect anything on the Income Statement because we accounted for the Expense earlier. There is a pattern here that discloses the secret to understanding the difference between Profit using the Accrual method and actual Cash Flow. Profit is not the same as Cash Flow. If Profit and Cash Flow were the same, it would be purely coincidental as long as we are doing Accrual accounting. This insight is important if you are to understand one of the mysteries of life.

Because our CPA tells us that our equipment can be Depreciated over five years, we will depreciate 20% of it this year. Depreciation is an expense that we do not pay, called a non-cash expense. Depreciation is explained in more detail below. Our transaction looks like this:

Notice that we listed the "Less: Depreciation" Account on the Asset side of the Balance Sheet. That’s another long-standing tradition and this one makes sense too. If we look at the Balance Sheet and only see that we have $5,000 in fixed assets, we only have part of the story about fixed assets. We also need to know how much depreciation has been taken against them. In our case, we only have $1,000 in depreciation. That tells us our fixed assets are relatively new. If the amount of depreciation were $5,000, we would need to be checking our fixed assets to see if they are worn out or in need of repair.

Another Credit balance that we could show on the Asset side of the Balance Sheet is a "Reserve for Losses" that we might have for our Accounts Receivable. If we are trying to keep our profit accurate (and reduce taxes), we should recognize that part of our Accounts Receivable are probably not going to be collected, so it won’t end up being profit. At the moment, we might not know which part is not going to be collected, so we make a reserve for "unidentified" losses. When a loss becomes certain and we know who won’t pay, we Debit the Reserve Balance and Credit Accounts Receivable.

Depreciation "Expense" has nothing to do with cash flow, yet profit dropped $1,000. Proof again that Profit and Cash Flow are not the same.

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