In simple terms, accounting is where the expenses and revenues are recorded on the balance sheet. There are two different ways to do this. The first is cash accounting where nothing is recorded until the money actually is exchanged. For example, if a sale is made, the revenues are not recorded until after the customer pays for the product. Then the commissions that are owed to the salesperson are not recorded as expenses until after he is paid.
Where some businesses use cash accounting, other organizations use accrual accounting. In a business or organization, accrual accounting is the financial “adding together of interest or different investments over a period of time” (Wikipedia.org). In other words, when the transaction is made, the revenues and expenses are recorded, even though cash has not changed hands. An example of this is a car dealerships that offer a “buy it here, pay it here” deal. In these used car dealerships, the customer makes a down payment on a car. Then they make affordable weekly or monthly payments until the car is paid off. The business still sees the sale as revenue, even though the cash will not be available until after the accounting period is over. Since the salesperson gets his commission at the completion of the sale, the expenses are also recorded on the balance sheet. Many businesses prefer this type of accounting because of the benefits that come with it.
Accrual expenses can be counted as tax expenses even if the customer has not finished paying for the sale. The tax deduction is taken during the year when the transaction originally began.
Accrual accounting can be used to make forecasts in the future. For example, there may be so many sales within a period of time. By looking at the revenues and expenses during that period, the managers can make predictions a year or even longer down the line. This is useful to both the organization and the lenders.
Many businesses need some sort of financial assistance from a lender. Accruals give banks an idea of how the organization is doing financially. With accurate accrual accounting, lenders will be able to determine if the organization can afford to borrow money. The banks also can make an assumption of how the business will do in the future.
In addition to lenders, organizations rely on suppliers for different items to support their business. For example, an auto body shop will need to purchase different tools and parts to allow the operation to flow smoothly. Accrual accounting tells the suppliers how the organization is doing and whether it will be worth their time and money to have a relationship with them in the future.
While cash accounting appears to be a simple way of recording the revenues and expenses, it is better to use accrual accounting. Cash accounting may work if the business has a small customer/employee base. However, if a business has more than fifty employees and has an international or global presence, accrual accounting is more beneficial for the financial health of the organization.
