When you start your own business, there’s a long checklist of things you have to do in the beginning stages. Business plan written? Check. Advertising to customers? Check. Inventory in stock? Check. Accounting method selected? Wait, stop right there.
Accounting is one of the most important aspects of your business. With good accounting, you’ll be able to track the revenue and expenses of your business. Accounting helps you assess how your business is doing, and it simplifies filing your income taxes each year. In other words, accounting for your business isn’t just an option — it’s a necessity.
But what if you don’t know the first thing about accounting? Luckily, you don’t have to have a degree in accounting hanging on your office wall to get the basics. Even new business owners that don’t have the money to hire a dedicated accountant or bookkeeper can keep up with the books using the latest accounting software.
But before you start shopping for software options, there’s one critical decision you need to make for your business: will you use cash-basis or accrual accounting?
Unsure of what these terms mean? Then you’re in the right place. In this article, we’re going to look at the two major methods of accounting. We’ll dive into the benefits and drawbacks of each, the factors to consider before making your selection, and even a few software recommendations based on the method that you’ve chosen. Read on to find out more about these two methods and which is the right choice for your business.
What Is Cash-Basis Accounting?
The first accounting method we’re going to discuss is cash-basis accounting, also known simply as cash accounting. With cash-basis accounting, transactions are recorded when revenue has been received and expenses have been paid. Cash-basis accounting does not use accounts payable or accounts receivable. Instead, these transactions are only recorded when the cash changes hands.
Let’s simplify this concept with an example. Suppose your business has received $5,000 in payments from customers, and you have $2,000 in unpaid invoices. You have already paid $1,000 in expenses for this month. However, you have a bill from your supplier that is $500 that you haven’t yet paid.
Using cash-basis accounting, you would record the transactions for all payments you’ve received ($5,000). You would also record all expenses that have already been paid ($1,000). The unpaid invoices ($2,000) and unpaid expenses ($500) would not be recorded until they were paid. This would show that we had a total profit of $4,000.
A little later in this article, we’ll use this same example to see how the numbers change when using the accrual method.
The Advantages Of Cash-Basis Accounting
When deciding which accounting method to use in your business, you’ll want to fully evaluate the advantages and disadvantages of each. There are several benefits to using cash-basis accounting, including:
- Tax Advantages:Â One of the major benefits of using the cash-basis method is that you won’t have to pay taxes on revenue that hasn’t been received by the end of the year. Instead, you would pay taxes on the income the following year after payments have been received.
- Simplicity:Â This method of accounting is fairly uncomplicated, which could benefit a small business owner with a lack of accounting experience.
- Current Cash Flow: Cash-basis accounting gives you a more accurate picture of your current cash flow. This method allows you to see exactly how much cash you have on-hand at this point in time.
The Disadvantages Of Cash-Basis Accounting
Of course, we can’t talk about the benefits without looking at the drawbacks of cash-basis accounting. The disadvantages of using this accounting method in your business include:
- Tracking Accounts Payable/Accounts Receivable:Â The cash-basis method doesn’t track accounts payable and accounts receiveable. While this does save time in recording transactions, it can also be easy to lose track of who you owe money to … and who owes money to you. If you use this accounting method, you have to have some type of system in place to ensure that you’re collecting the money that’s owed to you and paying what you owe in a timely manner.
- Higher Risk Of Errors:Â While cash-basis accounting may be easier, there is a higher chance that errors will be made. The double-entry system used with accrual accounting makes it easier to catch and correct errors. Learn more about double-entry accounting and its benefits.
- No Long-Term View: Cash-basis accounting gives you an accurate picture of your company’s finances in the here and now, but it doesn’t provide an accurate view of your financial health over the long term. Let’s say you have a lot of cash on hand now. While this looks good for your business, further analysis could show that all of your customers have paid, you have many unpaid expenses, and business has been slow. In other words, things look good now, but they may not stay that way.
- IRS Restrictions:Â Not all businesses can use this method of accounting. According to the Internal Revenue Service, businesses with over $25 million in revenue over the last three years must use the accrual method of accounting.
What Is Accrual Accounting?
The other method to consider for your business is accrual accounting, which is the more commonly used accounting method among business owners and is generally more recommended by accountants. When your business uses the accrual method, transactions are recorded when they occur. When a job is completed for a customer, for example, the transaction is recorded whether or not the customer has paid. If your business receives a bill from a vendor, this expense is recorded even if you aren’t paying it immediately.
These transactions are posted as accounts payable and accounts receivable.
- Accounts Payable: Accounts payable are expenses that your business owes but hasn’t yet paid.
- Accounts Payable: Accounts receivable is revenue that you’ve earned but haven’t yet been paid.
Now, let’s go back to the example we used for cash-basis account to show how accrual accounting works. Your business has received $5,000 from customers this month. You have an additional $2,000 in unpaid customer invoices. Your paid expenses for the month are $1,000. You have unpaid expenses totaling $500.
Unlike cash-basis accounting, if you were using the accrual system, all of these transactions would be recorded right away. If you wanted to calculate your profit or loss for this time period, you would first add all of your earned revenue — whether you’ve received payment or not. Adding the $5,000 you’ve received with the $2,000 in accounts receivable would give you a total of $7,000.
From this number, you would subtract your expenses, whether or not they have been paid. You would subtract $1,000 in paid expenses and $500 in unpaid expenses from your total revenue of $7,000. This would reflect a profit of $5,500 — quite different from the $4,000 profit we calculated using the cash-basis method.
The Advantages Of Accrual Accounting
Why would you choose accrual as the accounting method for your business? There are a number of advantages:
- Fewer Errors: The accrual method uses double-entry accounting. This means that every transaction is posted to at least two accounts, keeping your books balanced. While double-entry accounting is more time-consuming, it does make it easier to spot and correct accounting errors.
- Long-Term Cash Flow: While cash accounting might be better for gauging your current cash, accrual accounting gives you a clearer picture of the long-term cash flow of your business. This is a tremendous asset for budgeting, planning, and decision-making.
- Obtaining & Tracking Funding: Whether you’re seeking investors or a loan from a bank, the accrual method of accounting allows you to run statements that give a better picture of your company’s future, which could improve your chances of getting a loan. For investors and lenders, this shows if your company is a risk and could be a factor in determining if you’re getting funded. After you receive a loan, credit account, or other form of financing, using the accrual method will also make it easier to track these accounts.
The Disadvantages Of Accrual Accounting
Accrual accounting has several big advantages for your businesses, but there are also a few drawbacks to keep in mind:
- More Complicated: Accrual accounting uses double-entry accounting, which we’ve already established has its benefits. However, this does make it more complicated and time-consuming than cash-basis accounting. Fortunately, though, there are plenty of good accounting software options available that eliminate the need for manual calculations, in most cases.
- Tax Implications: When you use the accrual method, all earned income is recorded. Some of this income may not have been received yet, but it will still be reported on your tax return. For example, if you have $5,000 in unpaid invoices at the end of 2019, these earnings are recorded in your accounting software and reported on your taxes for 2019, even if you don’t actually receive the money until 2020.
- Current Cash Flow: Accrual accounting gives you a great overview of your business finances over the long term. However, it doesn’t give you a good picture of your cash flow at this moment. For instance, your books may show that you have quite a bit of money, but some of this could be money that has been earned but not yet received. When using the accrual method, you must keep track of cash to know how much money you have on-hand in the present.
Which Accounting Method Is Right For My Business?
By this point, you should have an understanding of the two accounting methods. Even though we’ve gone over the pros and cons of each, you may still be on the fence when it comes to choosing the right method for your business. If you’re still feeling unsure, consider these factors and situations to help you make the best decision for your business.
Factors To Consider
When determining which method is right for your business, keep the following factors in mind:
If one of the goals of your business this year is to seek funding, investors and lenders generally want to see numbers that reflect the long-term financial health of your business. This is more accurately reflected when the accrual method is used. Furthermore, using the accrual method makes it easier to track what you owe to creditors and lenders.
If you extend credit to many customers and/or send invoices to customers, the accrual method will help you accurately track what you are owed as accounts receivables.
Filing Tax Returns
Choosing the cash-basis accounting method does have some tax advantages. For example, if you’re a small business with many unpaid invoices at the end of the year and you use the accrual method, having to pay taxes on this income that hasn’t been received could negatively affect your cash flow.
Size Of Your Business
If you own a small and simple business without too many customers, the cash-basis method could work for you. However, if you have a very large business with many customers and complex transactions, the accrual method is typically a better fit for your business.
Monitoring Cash Flow
If one of your most important goals is to monitor how much cash you have on-hand in the present, stick with cash-basis accounting. If you would rather have a long-term overview of the cash flow of your business, choose the accrual method.
When To Use Cash-Basis Accounting
Cash-basis accounting is best for small businesses, sole proprietors, and freelancers that want a simple way to track income and expenses. This type of accounting is best for cash-based businesses, businesses that do not keep inventory, and smaller service companies.
If cash-basis accounting is what you choose for your business, there are plenty of great software options available. One important thing to note, however, is that some software programs may say they offer cash-basis accounting, but in reality, they just offer the ability to run reports as cash-basis. If you want a cloud-based option that allows you to track your finances using the cash-basis system, QuickBooks Online is one of the most popular choices among business owners and entrepreneurs. Want to take your accounting offline? QuickBooks Desktop is another solid option to consider.
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When To Use Accrual Accounting
Most small businesses opt to use accrual accounting — and most accountants recommend accrual over cash accounting. Although it is more time-consuming and complex than cash-basis accounting, the good news is that there are plenty of software options that simplify the process. While you do have to learn and understand the program you choose and manually enter some data, today’s accounting software offers a variety of features, such as automatic bank reconciliation, receipt scanning, recurring invoices, and payment reminders.
As previously mentioned, there are some businesses that don’t need to use accrual accounting. Small service-based businesses, businesses that primarily operate on a cash-basis, businesses that don’t have inventory or extend credit to customers, freelancers, and independent contractors may find that cash-basis accounting best suits their needs.
Even if this sounds like you, as your business grows, you’ll want to consider the benefits of accrual accounting. Or maybe you’re already there. If so, your next step is to find the right software for your business. Some of the most popular options include Wave, Xero, Zoho Books, and QuickBooks Online.
The Bottom Line
When you’re an entrepreneur or business owner, one thing that should never be overlooked is accounting. Whether you plan to hire a bookkeeper or you’re simply going to take this task on yourself, it’s extremely important to choose the method that will work best for your business. If you’re still unsure of which is the right choice, you can always talk to an accountant to learn more about the pros and cons of each method. If you have made a decision, you can get started by checking out our software recommendations above or comparing some of the best software options on the market.
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