When to Record Transactions
In accounting, as in most other things, timing is everything. That applies to transactions themselves, in two different ways. The first involves the day the transaction actually took place (for example, you buy a box of copy paper and tell the store to bill your company). The second comes into play when money changes hands (you send out a check for that paper). These two things may happen at the same time (for instance, if you paid for the paper while you were still in the store), but equally as often they won't. The trick is knowing at which time you'll record the transaction, and that depends on the accounting method you decide to use for your business.
You have two distinct options to choose from for your overall accounting method: cash or accrual. The cash method, more commonly used by small businesses, means you record transactions only when money changes hands. Using this method, you wouldn't write up that paper purchase in your books until the day you wrote the check. The accrual method, which some companies have to use, requires that you record transactions as they occur regardless of the money factor. Under this method, you would write up the transaction on the day you got the paper, then use a second transaction to record the payment.
When it comes to choosing an accounting method, cash wins hands down over accrual. It's easier to understand: you record transactions when cash changes hands. It gives you a little leeway at year-end to minimize taxable income: you can pay a bunch of expenses early to reduce your profits and your tax bill for this year, and you pay taxes only on the cash you have actually received this year. Plus, it's simpler to keep your books; since all transactions involve cash, you need to write out only the accounts involved in the entry.
When you use cash accounting, virtually your entire bookkeeping system can be run through your checkbook. As long as you record every check you write and every deposit you make, you will have most of your daily accounting chores taken care of. Typically, the only extra recording comes in when you pay cash for some expenses (such as stamps).
There is a drawback to this much-preferred method, though. It doesn't track your revenues and expenses as they happen — only when there's a payment. Knowing exactly when the original transactions occurred could come in very handy for planning purposes, because you would know definitely the actual period in which the expense was incurred or revenue earned.
In addition, there are some companies that cannot use cash accounting, according to IRS regulations. If your company has inventory, you can't use cash accounting. You also can't use this method if your company is formed as a C corporation, or if your gross revenues are more than $5 million a year (a very good problem to have). If you aren't sure whether your company can use the cash method, check with a tax accountant.
Using the accrual accounting method is a bit more complicated than the cash method, but it can provide you with better information. Keeping your books in this way requires double-entry accounting, which means you always have to specify which two accounts (or more, when applicable) are affected by any transaction. This is different from the cash method, because in that case, it is assumed that no matter which account you write the transaction to, the other one is the cash account.
The basic rule of accrual accounting is to record transactions as they happen, even if no cash is involved. You record every revenue as it is earned, and every expense as it is incurred. The underlying accounting principle here is called the matching principle: you match revenues and expenses to the period in which they actually took place.
With the accrual method, the noncash entries are the ones that impact your bottom line. Their purpose is to record revenues and expenses right now. When you do pay those expenses or receive those customer checks, those transactions have no effect on your profits, since the transactions involve only assets and liabilities.
When you buy supplies on account, you record the transaction on the day you bought the supplies. When you make a sale to a client, you record the sale that day, even if your invoice doesn't ask him to pay you for another thirty days. Of course, when the cash does eventually change hands, you will have another transaction to record. Having to record those extra entries is one of the drawbacks of accrual accounting. The other drawback has a bigger impact on your bank account: you have to pay income taxes on revenues you have earned, even if you have not yet been paid.