Small business owners need to know exactly what’s going on with their business at all times. If you don’t have a finger on the pulse of your business, then you may think your business is thriving as you watch revenue roll in the door, but you could still be spending far too much and your company could actually be in the red. The most successful business owners always have a thorough understanding of how much money is coming in and going out.
There are two accounting methods that help business owners keep track of their revenues and expenses: accrual accounting and cash-based accounting.
The difference between these two approaches to accounting is how you record revenues and expenses. For accrual accounting, transactions are recorded right when they occur. For cash-based accounting, transactions are recorded when payment is received.
We’re going to take a closer look at these two approaches to balancing your books and go over the pros and cons of accrual accounting and cash accounting. Let’s get started so you can start getting your company’s books in order.
- What Is Accrual Accounting?
- Advantages of Accrual Accounting
- Disadvantages of Accrual Accounting
- What Is Cash Accounting?
- Advantages of Cash Accounting
- Disadvantages of Cash Accounting
- Record Transactions Now or Later
What Is Accrual Accounting?
Accrual accounting records all business transactions when they occur, regardless of whether or not a payment was made in the same period. Accrual-basis accounting paints a better picture of the current financial health of a business.
When a business implements accrual accounting, all business transactions are recorded when they occur, not when the cash is actually collected. These revenues are then simultaneously offset by all expenses incurred from the same transaction. This is known as the matching principle, and it requires businesses to record expenses on income in the same accounting period rather than in different periods.
Accrual accounting gives an accurate picture of a company’s well-being and is the most common practice for companies that intend to make more than $5 million in revenue or complete credit transactions. Technically, a company that has less than $5 million of yearly revenue can choose either type of accounting practice, but only a handful of small businesses and individuals will use cash accounting, which we’ll cover in further detail below.
Accrual accounting will give you an accurate reading of your company’s financial well-being. The only drawback is that it’s more labor-intensive and requires more expertise to implement. Therefore, it also tends to be more expensive if you aren’t running the books yourself, and harder to learn if you are.
When businesses started accepting more transactions on a credit basis, it became imperative to accurately track financial transactions and the overall health of companies. Business transactions are now often purchased on credit or are distributed over several months of payments. Accrual accounting makes sure that these transactions are accurately recorded during the same reporting period.
Accrual accounting gives businesses a crystal clear view of their overall cash flow. It enables companies to see all cash inflow and outflow on their financial statement during the accounting period.
Let’s dive into some of the advantages of accrual accounting.
Advantages of Accrual Accounting
The accrual method of accounting gives business owners a clear view of the overall financial health of their business. It also follows the Generally Accepted Accounting Principles, or GAAP, guidelines. These guidelines detail the rules and legalities of business and corporate accounting practices. Let’s take a closer look at the advantages.
Shows Your Company’s Financial State
When your company uses accrual accounting, you’re able to paint a clear picture of exactly what’s going on with your business. It allows you to see consumer spending habits as well as the income and expenses incurred during the reporting period.
This enables your company to effectively plan and manage finances to prepare for periods of low sales or more profitable peak months. Your company will have a better understanding of the big picture rather than focusing on short-term fluctuations.
Follows the GAAP
Accrual accounting is the preferred method of the Internal Revenue Service as it meets the GAAP guidelines. Any company that has more than $5 million in annual revenue must use accrual accounting practices.
Smaller businesses will likely not even come close to this high yearly revenue level. These companies can choose not to use accrual accounting, but using cash-based accounting may hurt their chances of qualifying for external funding. Some banks require it in order to receive loans or funding.
Disadvantages of Accrual Accounting
Although it’s the preferred accounting method for GAAP, accrual accounting does have its drawbacks. It requires more resources to implement, and it doesn’t provide a great view of short-term financial health.
Requires More Resources
Accrual accounting is more complex than cash accounting. It requires more expertise and can be complicated for a small business owner to implement on their own.
This means doing more paperwork and keeping a close eye on money coming in and out. It can be easy to mix up transactions and keep your books balanced on your own. If you’re not careful, you could miss something and not have enough cash on hand to cover expenses in future months. Your best bet would be to hire an accountant to make sure nothing slips through the cracks.
Provides an Unclear Short-Term View
While accrual accounting does provide an accurate view of a company’s financials in the long-term, it lacks the same visibility in the short-term. Since accrual accounting operates on the basis of tracking transactions when they occur rather than when cash is actually sent to your bank, it can be misleading for business owners.
For example, if you have $1,000 in sales on credit that won’t be paid for another three months, your bank account could have a balance of zero dollars in the current month.
Now let’s take a peek at the other accounting methodology: cash accounting.
What Is Cash Accounting?
Cash basis accounting is the other accounting method business owners can use. With this method, you record transactions only when you receive a payment. Business owners record revenues and expenses when they receive payment instead of when the sale actually occurs.
For example, if you run a small graphic design business, you might decide to use cash accounting. Let’s say you sell your design services to a client in April. If you send an invoice for your services and your client doesn’t pay their balance until June, you’ll record your revenue in June rather than April. If you were using accrual-based accounting, this revenue would have been recorded in April when the transaction occurred.
The cash method is used by very small businesses that make less than $5 million in revenue, like sole proprietorships and partnerships. This method is also common among businesses that don’t have many credit transactions. It’s a much simpler accounting approach that makes it easy for owners to handle their books on their own.
Advantages of Cash Accounting
Cash accounting is a simplified accounting practice that’s easy for small business owners to implement. It also has some tax benefits that can help you out at the end of the year.
Is Simpler to Use
Cash-based accounting is easier to handle than accrual accounting. You’ll simply need to keep track of money coming in and going out. You won’t have to worry about accounts receivable or accounts payable since you’ll only record transactions when receiving payment.
Comes With Tax Benefits
Small businesses can benefit from using cash accounting. With cash accounting, you’ll only be responsible for paying taxes when the payment occurs. This means that if you make a sale in December but don’t get paid until February, you won’t have to pay taxes on the sale until the next tax year.
This helps ensure you have enough cash on hand to cover your tax obligations. With the example we used above, you wouldn’t need to pay taxes on the December sale until the next year.
If you were using the accrual method and you made a very large sale that carried a high tax burden, you could potentially not have enough cash to cover it in the current tax year. With cash-based accounting, you’ll only be responsible for taxes in the tax year in which the sale was made — and you’ll always have this cash on hand rather than in accounts receivable.
Disadvantages of Cash Accounting
Cash accounting isn’t ideal for companies that plan on bringing in more than $25 million in revenue. It also gives a short-sighted view of a company’s financial health.
Provides a Blurred View of Your Financial State
Cash accounting is focused on the now. This can cause confusion and mix-ups in future months when you receive payment for services from previous months. It may seem like you’re pulling in a lot of revenue in one month when in fact this revenue was from another month’s work
Doesn’t Track Accounts Receivable or Accounts Payable
Your company won’t have an accounts receivable or accounts payable section on your balance sheet since sales are recorded when you receive payment. This can make it difficult to keep track of the sales you’ve made in previous months, which can cause confusion if you’re waiting for a client to pay their bill or if you have bills and expenses you need to pay yourself.
Doesn’t Follow the GAAP
While cash-based accounting works for small businesses, it’s not ideal for businesses that plan on increasing revenues past $5 million. This is because cash accounting doesn’t meet the GAAP standards for businesses that plan on reaching this revenue threshold. You should consider implementing accrual accounting if you think your company will hit this revenue threshold in order to follow the guidelines set by the IRS.
Record Transactions Now or Later
If you plan on growing your business into a larger operation that consists of higher revenues, more expenses, and many transactions on credit, then you should think about taking the accrual accounting approach. If you don’t want to invest the time or resources to implement accrual accounting, then cash-based accounting should do the trick. But remember, if your business starts taking off, cash-based accounting could get confusing, and you may be legally obligated to switch over to accrual-based accounting.
If you need assistance keeping your books balanced, make sure to check out a digital accounting system.