The cash method and the accrual method (sometimes called cash basis and accrual basis) are the two principal methods of keeping track of a business's income and expenses. In most cases, you can choose which method to use. Learn how they work and the advantages and disadvantages of each so you can choose the better one for your business.

In a nutshell, these methods differ only in the timing of when transactions, including sales and purchases, are credited or debited to your accounts. Here's how each works:

The accrual method.
Under the accrual basis accounting, revenues and expenses are recognized as follows:

Revenue recognition: Revenue is recognized when both of the following conditions are met:
    a. Revenue is earned.
    b. Revenue is realized or realizable.
( Revenue is earned when products are delivered or services are provided. Realized means cash is received.
Realizable means it is reasonable to expect that cash will be received in the future.)

Expense recognition: Expense is recognized in the period in which related revenue is recognized (Matching Principle).

The accrual method is the more commonly used method of accounting. Under the accrual method, transactions are counted when the order is made, the item is delivered, or the services occur, regardless of when the money for them (receivables) is actually received or paid. In other words, income is counted when the sale occurs, and expenses are counted when you receive the goods or services. You don't have to wait until you see the money, or actually pay money out of your checking account, to record a transaction.

Advantages and disadvantages of the accrual method.
While the accrual method shows the ebb and flow of business income and debts more accurately, it may leave you in the dark as to what cash reserves are available, which could result in a serious cash flow problem. For instance, your income ledger may show thousands of dollars in sales, while in reality your bank account is empty because your customers haven't paid you yet.

The cash method.
Under the cash method, income is not counted until cash (or a check) is actually received, and expenses are not counted until they are actually paid.

Advantages and disadvantages of the cash method
Though the cash method provides a more accurate picture of how much actual cash your business has, it may offer a misleading picture of longer-term profitability. Under the cash method, for instance, your books may show one month to be spectacularly profitable, when actually sales have been slow and, by coincidence, a lot of credit customers paid their bills in that month.

To have a firm and true understanding of your business's finances, you need more than just a collection of monthly totals; you need to understand what your numbers mean and how to use them to answer specific financial questions.