Cash Vs Accrual

Dear Dave
We have always relied on cash accounting to run our 20-person office. Our new office manager is trying to get us to switch to the accrual method. What is accrual accounting, and is this worthwhile?
JF MA

Dear JF
I’m going to go with your office manager on this. It’s time to increase the sophistication of your accounting operations.

Essentially, the difference between cash and accrual accounting has to do with the timing of when revenue and expenses are recognized for accounting purposes. For instance, under cash accounting, fee income is not recognized as income until the accounting period a payment is actually received from the client. Likewise, expenses are not recognized until the accounting period payment is made. By contrast, accrual accounting recognizes income and expenses in the accounting period in which the economic right to the income, and the obligation to pay an expense, is incurred without regard to when cash actually changes hands.

Due to the lag time in collecting client invoices at the typical engineering firm, cash accounting results in apples to oranges comparisons between income and expenses. In businesses like ours, the appropriate use of cash method accounting is for income tax reporting and paying purposes. After all, why pay taxes on income that you have not yet received? However, for internal management purposes, accrual accounting becomes the hands-down winner because it more closely matches income to the same set of expenses and conditions it took to generate said income. Accrual provides a true picture of ultimate profit and loss once the eventual cash transactions take place and is therefore more appropriate to draw conclusions from and base informed management decisions upon.

In the real world, many small to medium firms actually use both methods. They will employ accrual accounting (as they really should) for internal, month-to-month management information accounting and convert to the cash basis method at year end for tax reporting. Current versions of today’s engineering firm accounting packages offer you the option of viewing both methods simultaneously, or provide you the ability to toggle back and forth between the two methods at will.