When starting the bookkeeping for your business, you’ll need to decide whether to use cash- or accrual-basis accounting. The main difference between these two is the point at which you’ll record expenses and revenues.
The cash-basis method records revenue when cash is received from customers and expenses when cash is paid to suppliers and employees. It’s easy to determine when a transaction has occurred, and there is no tracking of receivables or payables. This method essentially tracks expenses in real time.
Accrual accounting records revenues and expenses as soon as they happen, regardless of when cash exchanges hands. This method tracks receivables and payables, provides a more detailed picture of revenue and expenses, and helps your business see ahead long-term.
The key difference between cash and accrual accounting lies in the timing of when revenue and expenses are recorded. Cash method records entries when money is exchanged, and accrual records at point of billing.
Here’s an example highlighting the differences between cash and accrual accounting. Imagine your business sells machinery, and you sell $5,000 worth of machinery. Under the cash method, the sale is not recorded until you receive the $5,000. With the accrual method, the $5,000 is recorded the day of sale, regardless of whether the buyer has made any payment.
The same principle works for expenses. Imagine your business has a bill for $1,700. Under the cash method, that expense would be recorded on the day $1,700 leaves your account. Under the accrual method, the expense would be recorded the day you received an invoice.
Accrual accounting also recognizes accounts receivables and payables which can provide a more accurate picture of the business’s long-term profitability. Differences in accounting methods may affect things like the quarter in which a sale is recorded or whether you’re tracking cash flow. These differences could affect the perceived profitability of your business, which is important when approaching investors.
The Best Choice for Your Business
The main advantage of cash accounting is its simplicity. This method simply accounts for cash paid or received, and makes tracking cash flow much easier. Cash basis accounting normally does not require additional staff which makes it a good choice for tracking personal finances.
On the other hand, cash accounting may not provide an accurate idea of your finances. Your business may look profitable simply because you have not paid bills yet, and it’s easy to lose track of expenses when you’re waiting to be able to pay them. Most accountants don’t consider cash-basis accounting to be an industry standard method.
Accrual accounting provides a much more accurate picture of your business’ finances. The inclusion of accounts receivables and payables paints a clearer picture of your long-term finances, giving you confidence in the financial decisions you make for your business.
However, accrual accounting requires that you monitor your invoices, not just your bank account. It’s important to have the resources of a knowledgeable accounting professional to manage your books on an accrual basis.
The Bottom Line
Cash accounting records financial transactions on the date of cash exchange, and accrual accounting records financial transactions on day of billing or sale. While each method has its uses, we recommend setting your small business up for success with accrual accounting. If you’re ready to enlist the help of expert accounting professionals, contact us for a free consultation!