In our previous post, we explored the basics of bookkeeping and its benefits and shared simple steps to enhance your bookkeeping experience. If you missed it, don’t worry! You can catch up by clicking the link[here]. Today, we’re taking it further by examining common business transactions under cash and accrual accounting and learning how to analyze and record them effectively.
Scenario: Understanding the Timing of Transactions
Imagine your business, Company YXY, purchased office desks from Furniture & Co. Limited on January 25, 2025, with a 30-day credit period. The payment isn’t due until February 24, 2025. Now, it’s the end of January, and you’re preparing your books. As you review this transaction, you pause and think: “Should I record this now? We haven’t actually paid for the desks yet, even though we’re already using them. Maybe I’ll wait and record it next month when we make the payment.”
This scenario captures many’s dilemma when starting: Do you record transactions only when cash changes hands?
The answer lies in understanding two essential accounting methods —cash basis and accrual basis.
Your choice between these two accounting methods plays a crucial role in determining how and when you record transactions.
Understanding Cash vs. Accrual Accounting
Cash Basis Accounting
In cash basis accounting, transactions are recorded only when cash is received or paid out. If you decide to wait until February 24, when the payment is made, you are following the cash basis method.
Accrual Basis Accounting
In accrual accounting, transactions are recorded when they occur, regardless of when cash is actually exchanged. So, if you record the transaction in January when the purchase occurred, you are following the accrual basis method.
The key difference is simple:
- Cash basis depends on cash movement.
- Accrual basis records transactions the moment they happen.
Which Accounting Method Should You Use?
Choosing the right accounting method ultimately depends on your business needs and goals. However, it’s worth noting that accounting standards, such as IFRS (International Financial Reporting Standards), GAAP (Generally Accepted Accounting Principles), and IPSAS (International Public Sector Accounting Standards), overwhelmingly favor the accrual basis of accounting. These frameworks prioritize accrual accounting because it provides a more accurate and comprehensive view of a business’s financial position and ensures consistency and transparency in financial reporting. But don’t panic—if your business is relatively simple and operates mostly on a cash basis, choosing the cash method is perfectly fine. Simplicity and practicality are key, especially for smaller businesses or sole proprietors.
Common Business Transactions: Cash vs Accrual Accounting
Now that we’ve covered the basics of accounting methods, let’s explore some common business transactions and how they’re recorded under each method.
Common Example 1: Sale of Goods
Scenario: Your company sold goods worth €5,000 on credit to a customer on January 25, 2025, with payment due on February 20, 2025.
Cash Basis Accounting: In this method, the sale of € 5,000 is only recorded as revenue in February when the payment is received from the customer, not January.
Entry on February 20, 2025:
- Debit: Cash €5,000
- Credit: Revenue €5,000
Accrual Basis Accounting: Here, the sale is recorded on January 25, 2025, when the transaction occurs, regardless of when the payment is received. This matches the revenue to the period in which it was earned.
Entry on January 25, 2025:
- Debit: Accounts Receivable €5,000
- Credit: Revenue €5,000
Entry on February 20, 2025:
- Debit: Cash €5,000
- Credit: Accounts Receivable €5,000
Common Example 2: Purchase of Goods
Scenario: Your business purchased office materials worth €600 on January 15, 2025, on credit, with payment due February 15, 2025.
Cash Basis Accounting: The transaction is only recorded on February 15, 2025, when the payment is made. No entry is made in January.
Entry on February 15, 2025:
- Debit: Office Materials Expense €600
- Credit: Cash €600
Accrual Basis Accounting: The expense is recorded in January when the materials are purchased, even though payment is made later.
Entry on January 15, 2025:
- Debit: Office Materials Expense €600
- Credit: Accounts Payable €600
Entry on February 15, 2025:
- Debit: Accounts Payable €600
- Credit: Cash €600
Common Example 3: Bank Interest
Scenario: Your business received a bank interest worth €1,200 on January 1, 2025, for the month of January.
Cash Basis Accounting and Accrual Basis Accounting: Since the bank interest is earned(received) in January, it is recorded as income in January under both accounting methods.
Entry in January:
- Debit: Cash €1,200
- Credit: Other Income €1,200
These examples show how the two methods differ. The cash basis records transactions only when cash changes hands, while the accrual basis captures transactions as they occur, regardless of when cash is exchanged.
Understanding the fundamentals of cash and accrual accounting, and how they work in real-world scenarios, can empower you to take control of your bookkeeping. The next step is to roll up your sleeves and apply this knowledge to your own business. By working through your specific transactions and experiences, you’ll gain a much deeper understanding of these methods. After all, as the saying goes, practice makes perfect- and the more you engage with these concepts, the more they’ll become second nature.