One of the early decisions your client must make is the selection of an accounting system to keep track of money going into and out of the business. There are two choices: the cash method and the accrual method.
Under the cash method, cash revenue is recorded when the cash is received and expenses when they’re paid. If the accrual method is selected, revenues and expenses are recorded when they’re incurred, regardless of when money changes hands.
For example, suppose your client places an order for goods on June 1 that’s paid upon receipt on July 1. Under the cash basis, the expense incurred for the purchase is posted on July 1, the date on which the merchandise was paid. Under the accrual method, the expense is posted on June 1, even though the order was not received or paid.
Accountants tend to prefer the cash basis for small businesses that are eligible to use this system because it’s simpler to use, requires fewer journal entries, and gives a clear picture of the company’s liquidity at any time. Its disadvantages are that it’s not permitted under generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS). Also, only companies that do not trade public stock, have earnings less than $1 million, or do not carry inventory as revenue are eligible to use this system
The accrual method may be used by any business and is also endorsed under GAAP and IFRS. Investors tend to prefer the accrual system because it ties journal entries for revenue and expenses more closely with the appropriate transactions. Even though this method requires setting up accounts that are estimated and must later be reconciled, it gives a clearer picture of your client’s cash flow and overall financial health.