Small businesses can choose one of two account maintenance methods: cash accounting or accrual accounting. The choice of approach varies from business to business, with most opting for accrual—and comes with its own set of advantages and disadvantages. There is no right or wrong way to keep your books—you’re obliged to adopt whichever system suits your company best.
Cash accounting vs. accrual accounting
There are some prominent differences between these two types of accounting, which have been elaborated on below. What is Cash accounting? When following the cash accounting approach, financial transactions are noted only after money has actually changed hands (i.e. when there’s actual cash to account for.) You would enter a particular amount in the credit column only after it was deposited in the company’s bank account. By the same token, an expense would be added to the debit side once it was actually deducted from the company’s bank balance.
What is accrual accounting? The accrual approach involves recording transactions after they’ve been committed to, but before they’ve been carried out. That is to say that as soon as an invoice has been raised, a client or customer payment is registered as having been made (even though the customer hasn’t actually remitted that amount. It just treats expected revenue as current revenue.)
All expenses would similarly be registered as soon as the company received an invoice for payment or purchase from a seller, even prior to actually transacting cash. So could accrual accounting work for your organization? To answer this question, let’s examine each method in a little more detail. We can then gauge whether they can be applied across the board or if each is best suited only to certain types of small business companies.
When is cash accounting appropriate? Cash accounting is the preferred method for start-ups and small businesses that don’t maintain an inventory. Small businesses that don’t have high-volume sales, and little to no inventory, are most likely to benefit from this approach.
In fact, some experts suggest that if your business makes less than 5 million USD a year and has been registered as a sole proprietorship, then cash accounting is the way to go. When is accrual accounting appropriate? Typically, companies with inventories find this approach best.
Inventories imply that a company has acquired and possesses a range of goods in bulk, in anticipation of future sales. Often, when making bulk purchases, small businesses are not in a position to pay their goods suppliers upfront. Since cash accounting records the actual movement of payments after they’ve been made or received, the company’s transaction with the supplier would remain unaccounted for until the end of that particular transaction cycle.
This can present a skewed picture of the company’s overall financial health. Businesses with high turnovers—more than 5 million USD—that are structured as corporations find accrual accounting to be the best fit for them. Take a good look at your business and it’s financial dealings before you make a final choice. Also, get advice from an accounting professional (like your accountant, if you have one.)