Accounting Type: Cash vs. Accrual
As a small business owner, maintaining an accurate account of your expenses is crucial if you want to stay afloat, and it's absolutely essential if you want to grow. While you may be passionate about your business, you may not be passionate about small business accounting. We're here to help.The two primary methods you'll need to know are cash basis accounting and accrual basis accounting. Even if you don't handle your financial reporting, it's vital to understand how each one works so you can choose the bookkeeping practices that will work best for your business.
With the accrual method of accounting, you record financial transactions when the deal is made, not when the money is transferred between parties. If a client's order generates expenses on your end, you record the revenue from the order as soon as the invoice goes out and the expenses as soon as you incur them.For example, let's say you get your monthly utility bill on the last day of August. The payment isn't due for 30 days, but you still record the transaction in August, as soon as you receive the bill.
Cash accounting is not as accurate as accrual, but it is the simplest and easiest to manage of the two methods. With this method, you record financial transactions every time cash enters or exits your account. You don't record income from a project until a customer pays you. You also don't record a deduction for a bill until a creditor accepts your payment.For example, if a payment is due on the last day of the month, you don't record it until the money leaves your account, which might happen the next month depending on processing time. If you wrap up a project in June but don't get paid by your client until mid-July, July is when you'll add that income to the books.
The cash method's key advantage is that it is so simple. It only accounts for cash paid or received. A disadvantage of this method is that it does not provide a clear overall picture of the company. For example, it might overstate the health of a cash-rich company that has large sums of accounts payables that far exceed the company's current revenue stream and the cash on the books. An investor might conclude the company is making a profit when the company is actually losing money.The accrual method, on the other hand, includes accounts payables and receivables. As a result, the accrual method is a more accurate picture of the profitability of a company, particularly in the long term. This is because the accrual method records all revenues as they are earned and all expenses as they are incurred. With the cash method, a company might have sales in the current quarter that wouldn't be recorded because revenue isn't expected until the following quarter. In this case, an investor might conclude the company is unprofitable when the company is actually doing well.One disadvantage of the accrual method is that it does not track cash flow. It might make a company with a significant cash shortage in the short term look bad, despite looking profitable in the long term. Another disadvantage of this method is that it can be more complicated to implement.
How to choose the right accounting option for your business
The accounting system and reporting method you choose for your small business depend on your resources, business goals, and your organization's financial requirements.In general, you're free to adopt whichever method makes more sense for you, unless your company makes over $25 million in gross annual sales. Some small businesses can choose a hybrid method of accounting, wherein you use accrual accounting for inventory and the cash method for your income and expenses.
Questions? Call Accounting & Tax Group.
If you're unsure of which accounting method is best for your small business, speak with a CPA or tax professional. Accounting & Tax Group can help. Call, email, or request an appointment with one of our tax experts today.
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