Accrual and Cash basis accounting.
Cash basis recognizes income when received and expenses
Accrual basis recognizes income when earned and
expenses when incurred.
These are the two most popular methods of accounting,
although there are some hybrid methods as well. Cash basis is the
method used by people in the day to day world. Money claimed when
it is received. If you work today, but get paid in two weeks, then
you have received (and have) no money. With accrual income is recognized
the moment it is earned, even if a client is not going to pay you
for weeks. Expenses are also handled differently. Using the cash
basis, we do not recognize an expense until we pay for it. For instance,
if rent is due on the first of the month and today is the third
and we have not paid it, then we have not incurred the expense.
Using accrual basis, we have an expense the moment it is incurred.
Therefore, the rent expense is recognized on the first, even though
the check has not yet been written for it.
While cash seems the easiest way to keep your records,
it is not nearly as accurate. For example, if you collect a lot
of money, fail to pay your bills, you will look like you are rich.
Nothing reflects the expenses incurred in order to make that money.
The phone bill, the rent, the electricity are all legitimate costs
incurred in order to make the income.
Accounting is built on principles governing the
proper way to allocate income and expenses. One of the foundational
principles is called the Matching Principle. This says that you
should match income with the expenses incurred in the same time
period. This is why accrual is a better way to accurately assess
your situation. If inventory is a big part of your business, then
the IRS states that you must use the accrual method of accounting.