If you keep your books on the cash method of accounting, this section is something you don't need to concern yourself with. If you keep your books on the accrual method of accounting, then please read on.
Without waging into the details of accrual accounting, understand that it is an essential tool for the financial management of your business. Primarily, it shows the performance of your business over a period of time by matching income and expenses. Regardless of the cash flow, the accrual method of accounting recognizes income when a sale is made. Likewise, it recognizes an expense when the expense is incurred. Most accountants recommend using the accrual method because they feel that it is the most accurate method for measuring how your business is doing. In fact, for some types of businesses, you must use accrual accounting for tax purposes.
However, accrual accounting does have some drawbacks. The main disadvantage of the accrual method is the timing difference it creates between the recognition of income and expense transactions, and the actual inflows and outflows of cash.
The cash method of accounting records the actual flow of cash through a
business. It recognizes income when cash is actually collected from a sale. It
recognizes expenses when cash is actually paid out, or when a check is written
to pay a bill. It is not concerned with matching income and expenses, but rather
the actual inflows and outflows of cash. This method of accounting more closely
resembles your cash flow.