Cash and Accrual accounting are the 2 ways companies report on their financial statements. And when planning for SMSF investing, understanding them is a foundation to reading the financials of a company.
Cash accounting records receipts are recorded during the period they are actually paid/received, and expenses are recorded in the period in which they are actually paid.
Accrual accounting records sales/revenue and expenses when they are incurred/billed.
When used – Small Businesses often use cash accounting because it is simpler and more straightforward, and it provides a clear picture of how much money the business actually has on hand. Companies, however, are required to use accrual accounting under generally accepted accounting principles (GAAP).
As an example,
Consider company X who orders some computers from company Y in Oct, but pays in Nov
By accrual the sale is recorded in Oct by company Y
By cash the sale is recorded in Nov when ACTUALLY received
If company Y needs to pay their supplier for the computers, they may have ordered in Aug and received early sept, but paid late Sept.
By accrual the Expense is recorded in Aug
By cash the sale is recorded in Sept – when ACTUALLY paid
One drawback of cash accounting is that it doesn’t provide an accurate picture of sales yet to be received (accounts receivable) nor expenses to be paid (liabilities or accounts payable) that have been incurred but not paid for, so the business might appear to be better off than it really is.
In all accrual accounting gives the BEST picture of a business.
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