For small businesses to thrive, it’s important to always keep an accurate account of all company-related expenditures. Not only does it keep your business afloat, but it’s also an essential step towards growth and development.
However, while accounting is a necessity, not everyone loves to deal with it – which is pretty understandable. Some business owners prefer managing their business more than having to go through accounting. But never fear, as accounting isn’t as complicated as it may seem. All it takes is knowing the right procedure to follow.
When it comes to accounting, there are two methods that you’ll need to know: accrual basis accounting and cash basis accounting. Even if you have an in-house accounting who’s doing all the accounting work for you, it still pays to know and understand how each method works. That way, you’ll be able to select the best bookkeeping practice that suits your business’s needs.
In this article, we will discuss accrual accounting and cash accounting to determine which one is the better option for you. First, let’s define each of the two accounting methods.
What is Accrual Accounting?
Accrual accounting is a type of accounting method that’s usually used if your company follows the accounting standards outlined by the GAAP (generally accepted accounting principles). Through the use of this accrual accounting, you’ll get a clearer overview of your company’s overall financial state.
Using the accrual method for accounting, a company’s income and expenditures are recorded whenever they are billed, regardless of when and how the payment will be received. For example, if your small business bills $1,500 in income on April 1, you would record that same amount as income in April’s bookkeeping – even if you received the funds on a much later date (e.g., May 20).
The same goes for your expenses. For instance, if your small law office purchases paper and stationery supplies on a credit in July, but doesn’t pay the bill until August, you would still record that transaction as an expenditure for July.
Benefits of Accrual Accounting
Accrual accounting provides a more comprehensive and long-term overview of how your company is doing financially. This type of accounting method provides an accurate presentation of the amount of money your company has earned and spent within a particular period. It also gives you an idea of when your company should consider speeding up or slowing down over the course of a quarter or a full year.
In addition, accrual accounting also follows the nationally recognized and accepted standards of business accounting. That means if your business were to grow, its accounting method would not need any significant changes. Apart from that, here are other benefits that accrual accounting can provide:
Clearer and More Accurate Financial Outlook
While accrual accounting is a bit more complex than cash accounting, it does give small business owners a better and more realistic idea of the state of their income and expenses during a given period. The information that you get from this type of accounting method is valuable as it gives you a clearer and more accurate outlook of your financial status at any point of the year. It also gives you a better understanding of consumer spending habits, which would allow you to make the necessary adjustments and plan better for potential peak months of your business operations.
Follows Standard GAAP Rules
Another notable benefit of accrual accounting is that it strictly follows the Generally Accepted Accounting Principles (GAAP). This level of comprehensiveness makes it an absolute necessity for companies with more than $25 million annual income.
We know what you’re thinking, and yes – $25 million in sales and revenue may seem very high for the majority of small businesses. That’s why in most cases, you’ll only be using accrual accounting if your bank requires it.
Downsides of Accrual Accounting
Accrual accounting has a lot of positives to showcase. However, it also has its share of drawbacks that you also need to know. The most notable of these disadvantages is the complex procedure. It also displays high inaccuracies of a company’s short-term financial situation. Apart from that, there are other disadvantages that you’ll find in accrual accounting:
It’s More Resources-intensive Option
Accrual accounting comes with complexity and more paperwork to your financial reporting process, which makes it more expensive to implement for most small businesses. Since you’ll record revenue before they even receive the money, cash flow has to be tracked in a separate manner to make sure your company can cover the monthly bills.
Inaccurate Short-Term Financial Overview
While it does provide a better long-term view of your company’s finances, accrual accounting provides an abysmal short-term financial overview. The cash method, which we will discuss in the next section, gives you a much better picture of the funds inside your bank account. The reason for this inaccuracy is because it also takes into account money that is yet to come into your bank account.
Because of this, accrual accounting can be a devastating option financially for small business owners. For instance, your bookkeeping could show a large amount of revenue when your bank account has zero balance.
What is Cash Accounting?
Cash accounting is a simple and more applicable accounting method for small businesses. In its most basic description, cash accounting records income as it’s received and expenses as they are paid. You don’t need to make ghost recordings of cash that are not yet there like what the accrual method does.
For example, if you invoice a client for $1,500 on April 1 and receive payment on May 15, you will record the income as money received for May. So, the general rule is that you’ll only record income when you actually receive the payment and it’s already available in your bank account.
It’s also important to note that the cash method doesn’t take into account your account receivables and payable. The reason for this is that it only applies to payments from your clients when payment is received. So, whether it’s in the form of on-hand cash, credit card receipts, or checks, cash accounting only works once your client settles their account and pays you whatever method they find convenient.
Similarly, cash accounting will only record your expenses whenever money leaves your account to pay expenses to vendors, suppliers, and other third-party goods or service providers. So, if you run a law office that purchased the paper and stationery supplies via credit in July, but didn’t’ actually pay the bill until August, you would record those purchased supplied as an expense made in August.
If your small business makes less than $25 million a year and it also doesn’t sell merchandise directly to customers, cash accounting is the ideal accounting option. In fact, it’s usually the most used method of accosting for most small businesses, such as partnerships or sole proprietorships.
Benefits of Cash Accounting
The cash accounting method has a lot of benefits to offer small- to medium-sized businesses. The most notable perk is the ease of use and much-improved cash flow capability. Apart from that, there are other perks that cash accounting brings to the table:
A Simplified Accounting Process
Many small businesses prefer the cash method for its simplicity and straightforwardness. Its simplicity is comparable to that of an average person tracking their personal finances. Since you won’t be recording your accounting payables and receivables, using the cash method also makes tracking money easier as it moves in and out of your bank account.
For small businesses that operate primarily through cash transactions while not maintaining large product inventories, the cash accounting method can be of great convenience. It’s a reliable way to keep track of your revenue and expenses without needed to deal with complicated bookkeeping.
Better Income Taxes
When it comes to dealing with your taxes, cash accounting is an advantage in this area. With cash accounting, you won’t have to pay taxes on funds that you haven’t earned yet. For instance, if you invoice your customer for $1,500 in September and don’t get paid until January, you won’t have to pay taxes on that income until January of next year.
The cash method helps you save money on your taxes, as well as improving overall cash flow. It ensures that your small business will have the funds available for tax payment whenever you need to settle your annual tax income return. For even small businesses, cash accounting can be crucial to keeping your business open, especially when cash flow is scarce.
Downsides of Cash Accounting
While the cash method is the simpler and more ideal option for small business accounting, it’s not free from its share of drawbacks. With that said, here are some notable disadvantages of cash accounting:
Inaccurate Financial Picture
Since it doesn’t take into account all incoming revenue or outgoing expenses, the cash accounting method can leave you to believe that you’re having a high cash-flow month when, in fact, it’s only a result of a previous month’s supposed income.
No Records on Your Accounts Receivable or Payable
Since the method is so straightforward, it doesn’t require your bookkeeper or accounting to keep track of the actual dates that correspond to specific purchases or sales. That means there are no records of accounting payable or accounts receivable, which can potentially create challenges when your company doesn’t receive immediate payment or has outstanding bills to settle.
Doesn’t Conform to GAAP
At this point, you may already know that the cash accounting method is the direct opposite of the accrual accounting method. So, while the latter does follow the Generally Accepted Accounting Principle, the former doesn’t. That means if your business were to grow larger than $25 million in annual sales, you would need to transition your accounting process from cash accounting to accrual accounting.
Which is the Right One for Your Business?
Accrual and cash accounting are completely different from each other. However, choosing the right one will depend on the financial status of your business. The rule is simple, if your small business is earning less than $25 million per year, you should opt for the simple cash accosting method. However, if it goes above that threshold, you should opt or transition towards the more complicated yet comprehensive accrual accounting method.
At the end of the day, it’s important to know when you’ll need a specific accounting method for your business. If you’re just starting, cash accounting is the go-to option. But if you’ve grown your business to a point where you’re earning $25 million or more, it’s time to transition to accrual accounting. If you want to learn how ReliaBills works, feel free to browse at https://www.reliabills.com/.