One of the first decisions you’ll have to make as a small business owner is which accounting method you’ll use to record the business’s transactions – cash or accruals. The difference lies in the timing: cash accounting records a transaction at the time the money changes hands – that is, when you receive a payment or pay a bill. On the other hand, accrual accounting records a transaction at the time the revenue is earned or spent, for example, when you issue an invoice or receive a bill. Put simply, cash accounting gives you a real-time view of how much money’s in the bank, while accrual accounting tells you how much money is owed to you at any given time.
The case for cash accounting
Cash accounting is the simpler method and reveals the real-time financial status of a business. Recording transactions on a cash basis means you only focus on the cash flowing in and out of your account. This method is helpful for identifying how much cash you have immediately available and, because you are only taxed on money you have physically received, it makes tax reporting more straightforward.
The case for accrual accounting
As cash accounting doesn’t track the money owed to you, known as accounts receivable, or the money you owe to your creditors, known as accounts payable, it’s easy for businesses using this method to confuse their long-term financial position. Why? Well, if you don’t account for money that’s expected to be paid to you or that you need to pay out, you won’t have an accurate view of your business’s future performance. Without this, it’s very difficult to plan and make sound decisions about where to spend or invest your profits.
Which method is best for you?
The cash accounting method tends to be best option for retailers and service providers who deal with a high volume of cash transactions and are often paid on the spot or very quickly. For example, if you run a bricks-and-mortar fashion business, where your customers pay for products before they leave the store, then cash accounting could work for you.
The accrual method tends to be better for businesses dealing with big contracts and large amounts of money that they often don’t get paid for immediately. For example, a business management consultant might only issue an invoice to a client after the project is complete. They could have spent weeks working on the project without receiving any money. The accrual accounting method will take into account the money owed on the project from the moment the contract is signed – giving a much more accurate view of profitability.
Cash and accrual accounting methods are just different sides of the same coin, with the difference being when that coin shows up in your books. Choosing between the two will depend on the size of your business, the type of transactions you make, the resources you have on hand, and whether you use an accounting software to manage your business finances.
For more tips on how to manage your small business’s finances, check out these resources.