As a small business owner, it’s important to understand the difference between the two main methods of accounting: cash and accrual. Even if you don’t handle your own financial reporting, it’s vital to know how each one works so you can choose the best bookkeeping practices for your business.
Let’s take a look at the differences and respective implications of each accounting method.
What Is the Cash Method?
With the cash basis of accounting, you record income as it’s received and expenses as they’re paid. This does not take into account any accounts receivable or payable, as it only applies to payments from clients when the cash is in hand, and expenses when the transaction clears your bank account.
For example, if you invoice a client for $1,000 on March 1 and receive payment on April 15, you would record the income in April’s bookkeeping. This is when the money was received and in hand.
Many small business owners choose the cash method of accounting because it’s a simplified bookkeeping process. It’s easy to track money as it moves in and out of your bank account because there’s no need to record receivables or payables.
Additionally, your small business doesn’t have to pay income tax on any revenue until the moment it’s deposited into your bank account.
One downside to using the cash basis of accounting is that it can produce an inaccurate overall picture of your finances. Since it doesn’t account for all incoming revenue or outgoing expenses, it can lead you to believe you’re having a very high cash-flow month, when in actuality this is a result of last month’s work.
What Is Accrual Accounting?
The accrual basis of accounting is basically the complete opposite of the cash method. Income and expenses are recorded when they’re billed and earned, regardless of when the money is actually received.
Using the example from above, and applying the accrual basis of accounting, you would record the $1,000 as income in March’s bookkeeping versus in April when you actually received the funds.
The upside to using the accrual method is it gives small business owners a more realistic idea of income and expenses during a certain period of time. This can provide you (and your accountant) with a better overall picture of how your business is doing and where it’s headed in the future.
One drawback to the accrual method is that it doesn’t account for cash flow or funds that are available in your bank account. If you don’t have careful bookkeeping practices, the accrual-based accounting method could be financially devastating for a small business owner, as your books could represent a large amount of revenue while your bank account is completely empty.
What’s Best for Your Small Business?
The cash method of accounting is the easier of the two to use and maintain, since it’s pretty straightforward. The accrual method, on the other hand, requires more bookkeeping because you’re forced to do more recording and tracking.
The cash method gives you a better picture of the funds in your bank account, while the accrual method accounts for money that’s yet to come in. The cash basis gives you an immediate look at your financial picture, while the accrual basis is more of a long-term view.
Some small businesses can choose the hybrid method of accounting, wherein they use accrual accounting for inventory and the cash method for their income and expenses. If you’re unsure of which accounting method is the best for your small business, speak with an accountant or tax professional.