Proper bookkeeping no doubt offers a lifeline for every business. From the first financial transaction, choosing the right accounting method to manage your financial transactions is vital.
As a small business owner, you have the option of choosing either cash or accrual accounting methods, which are the most popular. However, it’s important to be aware of both the advantages and disadvantages of either to make the best choice.
Cash and Accrual Accounting: What Are the Differences?
The distinction between cash and accrual accounting arises from the timing of revenue and expenses. A business that uses cash accounting records financial transactions when revenue is received, and expenses are paid. This method is common with smaller businesses and sole proprietors making it easy to track cash flow. Let’s say if you made a sale and invoiced a customer in June and then received payment in July, the income will be recorded as received for July.
Under the accrual method, financial transactions are recorded when revenue is earned, and expenses are incurred. Using the same example as above, your income is recorded for the month of June when you made the sale and invoiced the customer. This is regardless of whether the invoice is settled in July. The accrual method is more in use with larger organizations with complex transactions.
Pros and Cons of Cash Accounting
Many small businesses prefer cash accounting because it’s more straightforward. However, you should also consider the drawbacks which could impact your growth.
It’s Simpler to Use
Running a small business involves filling in more roles simultaneously, meaning time is precious. For this reason, cash accounting is easier to understand and manage. You don’t need to track multiple accounts, such as accounts receivable and accounts payable. You also don’t have to spend a ton of money setting up a system which is a plus as you need positive cash flow to keep running operations.
Save on Taxes
With cash accounting, you can minimize your tax bill. Since you record income and expenses when cash has been exchanged, you can time the transactions. You can choose to pay your expenses faster and slow down when income is to be received. This way, you have less revenue and more expenses on record, which translates to reduced tax profits during a tax year.
Easier Time Tracking Cash Flow
It allows you to follow the money as it goes in and out of your bank account. You are more certain of how much money you have in hand for planning your expenditure. There’s no need to worry about future payments and receivables, unlike with the accrual method.
It Doesn’t Offer a True Picture of Finances
Relying on cash accounting sets you on a potentially risky path for your business’s survival. It fails to give you a deeper view of your financial health as it mostly focuses on simple cash transactions. It does not reflect on income that has been invoiced but not yet received. It also ignores future expenses. This gives a false reality of your business’s liabilities leading you to think you’re profitable.
Difficult to Transition From Cash to Accrual Basis
At some point, your business will experience growth, likely surpassing the $25 million gross revenue mark in sales revenue. If this happens, as per the GAAP, you’re required to use the accrual method. This will involve making multiple adjustments, such as recording debtors, creditors, and stock.
Not every business can operate on a cash accounting basis. As per the IRS, you’re not allowed if you have inventory, are a corporation, make credit sales, or earn gross receipts of over $5 million annually.
Pros and Cons of Accrual Accounting
If you’re considering the accrual method for your business, you need to be familiar with the potential risks and benefits.
Gives a More Accurate View of Finances
The accrual method operates on matching your revenues to expenses. This gives a more real-time overview of profitability as revenues and expenses are recorded when earned and incurred respectively. You’re better placed to prepare financial reports such as cash flow and a balance sheet that tell a clearer story about your business’s health. As a result, you can confidently plan for the future as every important aspect has been accounted for.
If in the future your business expands and rakes in more than $25 million, then you have no choice but to shift to the accrual method. The GAAP views accrual accounting as offering a true representation of your financial statements. If you are already managing your operations with the accrual method, you will avoid the administrative burden down the line.
Easy to Make Strategic Plans
Accrual accounting can effectively tell you where the business will be in the next five years. Accounting for future revenues and expenses makes it easy to budget for expenses and predict your revenue trends. It can also tell if you’re nearly due for cash flow shortages or a windfall. Overall you can develop a plan to handle any future events that may affect your business functions.
It’s a Complex Method
Because you have to record more financial transactions such as incurred expenses and earned revenues, it requires more time to make the system work. You may also have to hire new staff to handle the tracking and recording of transactions. You may consider outsourcing to an accounting service that may be more cost-effective.
It Can Be Misleading
Without a careful recording of revenues and expenses, it can make you think there’s more revenue than is reflected in the cash reserves. It needs solid bookkeeping practices to avoid missing any vital data.
Which Accounting Method Works for You?
Choosing between cash or accrual accounting depends on your business situation, such as the size of operations and revenue. In general, cash accounting works best for startups and small businesses with little revenue. On the other hand, accrual accounting is suitable when the business brings in more partners, including investors, which may require complex reporting. An accountant can help you take off the pressure of handling your financial reporting and managing taxes.
Do you need help making sense of the rules and steps it takes to meet the bookkeeping and accounting needs of your business? Cloud Friday is here for you. Do not hesitate to contact us.