Cash vs. Accrual Accounting

Eeny, meeny, miny, moe – how does your accounting system go? Well, you have a couple of choices. There’s cash-based accounting, which means that you record income once you have the cash in hand (or in your checking account). And you record expenses as you pay for them, like when you write a check to the photocopier repairman for his latest visit. Cash-based accounting is what most individuals use because it’s simple and straightforward. Small businesses also use it, but it can get a little tricky if you’re trying to collect on payables, if you extend credit to customers or buy on credit with suppliers.

In the accrual-based accounting method, you record income when you submit an invoice for the sale, whether or not you’ve been paid. Say, for example, you're an architect, and your new fab museum client, for whom your designing a new wing, cuts you a check up-front for half of your fee. It means you've received payment for work you haven’t done yet. By the same token, the museum may not pay you a dime until the project is done, but you still mark it down as income. Expenses are treated the same way; they’re recorded as expenses now, whether you pay for them right away or in 60 days.

If the accrual-based method sounds slightly confusing, that’s because the most of us use cash-based accounting in our day-to-day lives. But accrual-based accounting is generally considered to give a more accurate picture of a company’s financial status than cash-based accounting because it allows you to match up income (paid or not) with expenses (paid or not). With the accrual method, you usually record more transactions – for example, one transaction when you make a sale or close a contract, and then another transaction when the client or customer pays the invoice – which means more work for you. Then again, if you’re using accounting software to handle your books, the software will automatically take care of the grunt work.

Good Question

Last week, Laura Brown asked a question on our blog:

I think the vocab is totally helpful, although when i read the ones related to investments, i still am not sure how to take that information and make it work for me. do i call my 401k person? who is that? do i have to get an investor person? how do i know who to trust? these are my questions ...

Financial advisor and DailyWorth contributor Galia Gichon replied:

It sounds like you are ready to take the step of learning how to apply the vocabulary to your personal finances on a PRACTICAL BASIS.  If you want to do it on your own, there are some great books that boil it down to basics and make it work.  My favorites are: "Smart Women Finish Rich" by David Bach, "Get a Financial Life" by Beth Kobliner, "A Woman's Guide to Investing" by Virgina B. Morris and "My Money Matters" kit by Galia Gichon (that's me!).  

If you want to talk to a professional - which is a great idea as well - I would suggest an independent advisor -- specifically someone who doesn't sell investments, as the information they give you might be biased.  There are independent financial planners who charge an hourly fee, as opposed to getting a commission for selling you investments. Start by asking your friends and family who they know.

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