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Friday, March 2, 2012

What is accounting?

Accounting is often called “the language of business.” By this people mean that the meat of the business is communicated through facts and figures. If one is speaking of how a business is performing it is helpful to have some scorecard to use to decide if a business is doing well or not.

There are many types of accounting and many sub-sets. Things like financial accounting, forensic accounting, cost accounting and others.

We are often confronted with the question of should a company choose cash basis accounting or accrual accounting.

Cash Based Accounting is probably the most basic of the two. Under this method a sale takes place when the payment is received. An expense takes place when payment is made. Most smaller businesses start out with cash accounting. Using this method if the company is making a profit then cash is available after all expenses are paid. If a company goes to pay for something and there is no cash then no profit has been made provided the owner has not put his hands in the till for things that are not business related.

Accrual Accounting is different. Under accrual accounting a sale takes place when an obligation is made to sell an item. If Billy-Bob signs a contract to purchase milk from Charlene in April but, the milk won’t be delivered until June and payment won’t be made until July then Charlene records the sale the day the contract is signed. No product or money has changed hands but Charlene has a sale on her books. She also has a liability to deliver the milk.

Since no cash has actually changed hands Charlene shows a profit but can’t pay her workers to work because there is no cash. This is how many companies show a great profit up until the minute they blow up and file for bankruptcy.

The bottom line to all of this is that it is all about the cash flow. Cash is king. If you don’t have the cash to continue to operate then no amount of paper profit is going to get your company through.

In Redneck terms, if you don’t have the money in your hand, you did not make the sale. Plain and simple, once you have the money in your hands and the product has been delivered, then a sale has taken place.

It would be so easy to balance the books if everyone would choose cash. An outside investor could see that cash came in, product went out and some cash was left over after paying for things. But, it doesn’t work that way in the real world.

What experiences have you had with accounting?  In your opinion, which makes mor sense accrual accounting or cash accouting?

The opinions or advice listed in this blog or website should be used as a place to start only. It is not a substitute for the use of a professional.
Please be sure to consult your attorney and/or accountant with any specific questions.
There is no one right answer to any business question that will cover all circumstances.
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