‘Cash accounting’ is when small businesses track their results by measuring how much cash comes in and goes out. ‘Accrual accounting’ is the more sophisticated accounting method most large companies use. But it can also make it easier to hide things or bend the truth.
Example: Driving for Uber
Say you’re driving for Uber and Lyft, and you need financial statements.
You’ll probably start with cash accounting, because that’s easiest, and because cash is what matters most to you anyway. Each month, you tally up how much cash you took in from driving, and how much cash you spent on things like gas, repairs, car washes, etc.
But there’s a problem. One day your car dies, and you have to buy a new one. It’s expensive ($24,000), so when you do the cash accounting for that month, it looks like you had a terrible month. When in fact, you drove a lot and it was one of your best months ever.
The solution? Switch to accrual accounting. With the accrual method, instead of recording the car’s full $24,000 cost as an expense that month, you just record a part of it, because you believe the car will last five years. So your car expense for the month is now $400, not $24,000… or one sixtieth of the purchase price (five years times twelve months). Suddenly things look a lot better on paper!
Accrual accounting is like telling a story – or painting a picture – because the decisions you make can change the numbers a lot. If you said your car was going to last ten years rather than five, for example, you’d have only recorded a $200 car expense, not $400, for the month. But what if you guessed wrong? To an outsider, that could seem misleading.
As you can see, you can tell almost any story you want with accrual accounting. But in the end, the truth (and the cash) always catches up with you.