Many business owners are the masters of their domain: the product or service, customer, managing teams, the market, etc… Many of them, however, are woefully uninformed about the very basics of bookkeeping and accounting. Whether you are about to start a new business, or even if you have been journeying along without much incident, it pays to know the basics. One of the more important basics is understanding the two principal methods of keeping track of business income and expenses: cash method and accrual method. These two methods, in essence, only differ in the timing of which sales and purchases are credited or debited to your various accounts. They also have a common shortcoming: they only give you a partial picture of the financial status of your business.
Cash Accounting. If you choose the cash method, income is only counted when cash (or a form of payment) is actually received, and expenses are counted when paid. Note that the IRS restricts certain entities from using this methods if grossing 5 million or more. One of the benefits of this system is that it gives a very accurate reflection of your cash flow. However, it can give a false impression of your expenses and revenue, and in essence, a misleading picture of long-term profitability. For example, your books may suggest that you had a wonderfully profitable month, but your sales may have been flat and perhaps you simply had a large number of customers pay their bills. To have an absolute understanding of your finances, you need more than just a collection of monthly totals; you need to understand what your numbers mean and how they can be used to answer questions about your financial situation.
Accrual Accounting. The accrual method records income when a sale is made, even if payment isn’t received right away. Expenses are recorded when the goods and/or services are actually received, not when they are paid. Therefore, while the accrual method shows the fluctuation of business income and debts more accurately, it may not reveal an accurate picture as to what cash reserves are actually available, which could result in cash flow problems.
Which Method Is Right For You? As you can see, each method has it’s pros and cons, and there is no preferred method for all businesses. One could also employ a hybrid accounting method. Some businesses may prefer one over the other due to a few key factors:
- Smaller businesses tend to prefer cash accounting because it is simpler and less time consuming. As a business grows, a switch to an accrual method is often needed to more accurately track revenue and expenses.
- Using the same accounting methods internally and for tax purposes is simply a good practice. This greatly simplifies the accounting process when calculating income and expenses.
- Depending on the type of business you operate, one method may be better than the other when filing taxes. For example, if you incur expenses in December of 2014, but don’t actually pay for them until January of 2015, you would not be able to claim deductions until the 2015 tax year if you choose cash accounting. With the accrual method you would still be able to claim tax deductions for 2014.