As the owner of an unincorporated small business, you can choose between the two types of accounting: cash accounting and accrual accounting. Cash accounting, also known as cash-basis accounting, means you record payments received and expenses you pay when the actual cash changes hands instead of when the triggering transaction happens. With accrual accounting, you record transactions when they happen, even if the cash exchange happens at a different time.
Cash Accounting Basics
Small businesses often use cash accounting due to its simplicity. Instead of logging transactions when you get a bill or create an invoice, you only have to record transactions when the money transfers. It also provides a clear picture of how much money you have available because you don’t record it until payments change hands. With accrual accounting, it may look like you have plenty of money on hand because you record transactions before you actually get the cash.
Cash Accounting in Action
Imagine a small retailer places an order for 10 handbags on June 15. You don’t actually ship the handbags until July 2, and the customer pays the invoice in July when they receive the handbags. With the cash accounting method, you record the sale in July even though the customer places the order in June because you don’t actually get the money until July. If you use the accrual accounting method, you record the sale in June when the customer places the order.
To clarify further, perhaps you complete a construction job on March 15 and invoice right away, but the customer takes the full 30 days to pay. You receive the payment and record the transaction in April when you get your cash. The accrual method requires you to record the transaction in March when the actual work takes place, even though you don’t have the money for your work yet.
Accrual Accounting in Action
The same idea works for your expenses. Say you get an invoice for raw materials on July 5, but you don’t actually pay the bill until August 2. If you use the accrual accounting method, you record the transaction in July when you get the invoice. With the cash method, you record that expense in August when you actually pay it instead of July when you place the order and get the invoice.
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