When someone mentions accounting methods, they refer to the set of rules that their company uses to decide when its revenue and expenses are recognized in their book of accounts. There are two main types of accounting methods that dictate these rules for businesses- accrual accounting and cash accounting.
These two methods each come with a distinct set of rules on when to use them and how. Which one you decide to use will depend upon your company’s needs and requirements.
So which accounting method should your small business choose?
What are the Types of Accounting Methods?
The two general methods of accounting are known as accrual and cash. These two methods will dictate how income is recognized based on the timing of transactional records in accounts. Each one will produce materially distinct financial records and reports.
On top of these two methods, there is a third grouping fitted explicitly to the inventory of a business. This is known as inventory accounting, and includes three specific methods known as FIFO (First In, First Out), LIFO (Last In, First Out), and the weighted-average process.
How to Use the Accrual Method of Accounting
Accrual accounting is the method that records a company’s transactions when the original transaction takes place. Therefore, accrual revolves around the event of a transaction, rather than the actual transfer of funds. This method regards the usage of something, as the time when the transaction should be recorded.
For example, a company receives its electric bill in the mail for the month of February, but they do not pay it until April. Using accrual, they will record this transaction when they receive the bill in February, even though they do not transfer funds out of an account until April.
Principle Rules of Accrual
Following accrual accounting means a business must adhere to two principals. First, the revenue recognition principle dictates the recording of revenue within the fiscal period where the sale occurs, even if the company has not received payment. The Matching principle follows this first rule, ensuring accrued expenses must be recorded in the same period as the revenue to which those expenses are connected.
How to Use the Cash Method of Accounting
The cash accounting method records transactions only when the cash element of a deal has switched hands. Cash accounting revolves around the actual transfer of funds to an event. Using this method means that a company will record a transaction when paid for, not when it has happened.
Taking the same example as above, the company receives its electric bill in the mail for February. Still, it does not pay it off until April. In the instance of cash accounting, the company would record the transaction in their books for the month of April, as that is when the transfer of funds takes place.
This method is straightforward and allows businesses to record their income when received, not when contracted. That being said, this method can also cause cash flow issues, so companies need to keep an eye on their cash flow statements.
What is the Best Accounting Method for a Small Business?
The accrual vs. cash accounting method’s differences fundamentally lay in the timing and recording of transactions. Various business types will find one, or the other accounting form will work best for them.
Accrual accounting is most commonly used by someone who is self-employed. They will record their earnings in the fiscal period they contract their work, even if they receive payment for it in the next period. The cash method is most commonly used by small businesses, especially when there is no in-house accountant. This basis of accounting narrows the gap of errors, as it creates a clear path of transactions that are easy to follow in the books.
However, in the instances of larger companies and corporations, they must always use the accrual accounting method as dictated by the Canada Revenue Agency.
Is QuickBooks a Cash or Accrual Method?
What makes QuickBooks so great for small businesses and accountants is its ability to use either or method. The application makes it easy to convert income and expenses from cash to accrual and back again. No matter which accounting method you choose- whether for self-employed or small businesses- the QuickBooks accounting software has you covered.