Companies can choose how they wish to record the money they bring in. The accounting method a company uses will determine whether it relies more heavily on realized income or recognized income.
Realized income is that which is earned. If a company ships out goods worth $10,000 and includes an invoice for those goods with 30-day terms, the company doesn't recognize the $10,000 in income until it has a check in hand for that amount.
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Recognized income, by contrast, is recorded but not necessarily received. If a company ships out $10,000 in goods and sends out an invoice with 30-day terms, it might record that $10,000 as recognized income before it gets paid.
Companies can track and record their income with one of two methods: the cash method, or the accrual method. While both methods are equally valid, companies must choose one or the other.
The cash methodThe cash method is popular with small businesses in particular, because it's the more simplified of the two. Under the cash method, income isn't recognized until received, just as expenses aren't deducted until they're paid. Companies using the cash method rely on realized income when determining how well they're faring; accounts receivable aren't counted as revenue. This method can also be advantageous from a tax perspective. Since income isn't recorded or recognized until received, a company doesn't have to pay taxes on outstanding unpaid invoices, but only on money it's already received.
The accrual methodLarger companies often opt for the accrual method to track and report income. Under this method, income is recognized as soon as a transaction takes place, regardless of whether the money is received. In other words, a company doesn't have to receive money to count it as income; it will recognize the amount in question as long as it has reason to believe it will be paid what it's owed. As such, a company using the accrual method will have to pay taxes on any recognized income it records, regardless of whether that income has been received at the time its taxes are due.
Some financial experts think the accrual method gives a more accurate picture of a company's financial standing than the cash method. The downside, however, is that the accrual method tends to require a more careful monitoring of cash flow.
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