You have more to do with accounting than report your transactions! The reports describe the assets and liabilities of the company. It also helps you to prepare, schedule, make major financial decisions, and evaluate the company’s overall efficiency.
But the option is not that smooth and dry! There are two main types of accounting: cash accounting and accrual accounting. So, how do you know which of the option for your company fits best?
In this article, we will research the distinction between cash and accrual accounts. We shall cover the benefits and pitfalls of both approaches, and you shall have a summary by the end of this article.
Here is what we will cover:
- Cash method
- Accrual method
- What it means to “record transactions”?
- Which Accounting Method Is the Best Choice for a Small Business?
The Cash method:
The profits and expenditures are reported as paid with the cash base accounts. This ensures that when the cash is paid, only when cash is deposited into your hands (or bank account) and only when you pay outgoing funds. Any unsettled or overdue invoices shall not be reported until they have been done.
For instance, if in February 2019 you invoice a customer for US$500, but they will not pay you until June 2019, the income is reported in June and not February.
Since it’s a convenient, straightforward accounting process, small business owners and others who track their finances choose cash accounting. According to the Internal Revenue Service, however, corporations that “produce, buy or sell goods” are expected to manage inventory and use the accrual accounting system for tracking sales and purchases of goods (i.e., not cash basis accounting).
Pros of using Cash accounting:
- It’s simple and straightforward. The cash approach is direct, so items like accounts receivable and accounts payable do not have to be followed up. When you monitor your financial reports, cash balances are as simple as the entry of profits and costs.
- They don’t make a big difference to the taxes of the income. You must pay taxes only on income generated during a given month of cash accounting. You don’t have to pay penalties on any overdue sales, so the business has a more substantial cash flow.
- It provides you with a daily financial record of your business. Accounting in cash gives you a regular image of how you are performing financially.
Cons of using Cash accounting:
- You have no lists of accounts due and receivables from cash-based accounts. You don’t have a full view of your financial situation without a list of what you are owing and what you owe. For instance, if you still have your bills payable for the month, cash-based accounting could cause you to assume you have more money than you actually did.
- You can’t make long-term choices. You cannot make the required adjustments to enhance the way you conduct business without a good view of how much consumer/customer debt impacts your sales.
- It will not be used if the company has an annual revenue of more than $25 million. The IRS notes that businesses that receive more than $25 million a year must use the accrual accounting form. When the business expands, you will have to apply a new accounting system.
The Accrual method:
Unlike the cash process, accrual accounting includes tracking income until an invoice is made and recording costs as paid. This means that you report earnings when you get to your bank account, and you make bill payment deductions before you get paid.
You use the accrual system to report the accounts receivable and the accounts payable in your books. Accounts receivable is the money you earn for the services from a client while. In contrast, accounts payable is money you owe another business, like your utilities provider or materials supplier.
So, for example, if you send an invoice for $200 in May 2019 but receive the money in October 2019, you make a record of that $200 accounts receivable in May 2019.
Pros Of Using Accrual Accounting
- It provides a more realistic, long-term picture of your finances. With a more detailed report of your cash flow, the accrual method enables you to make projections for your revenue stream in certain months, make contingencies for dry spells, and even pinpoint clients/customers who delay payments.
- It makes it easier to score investors. When you have a better understanding of your financial situation—and you have solid evidence that your business is profitable—it’s easier to convince investors to take a chance on your company.
- There is no need to change accounting methods when your business grows. The accrual method is the required accounting method for businesses that make over $25 million a year. Starting with the accrual method saves you the hassle of making the switch (which you can’t do mid-year, by the way).
Cons Of Using Accrual Accounting
- It’s tedious, time-consuming work. If you’re the head of your company and you’re handling bookkeeping too, keeping up with accounting accrual might prove to be too much work. For this, it might be wiser to hire a dedicated accountant.
- The accrual method can give you a false sense of financial security. Because you’re recording invoices that haven’t been paid yet, you can trick yourself into believing there is already money in the bank.
- It puts you at risk of paying taxes for income before cash is received. If a customer or client hasn’t paid before you must file taxes, you may end up having to shoulder the cost of income tax.
What it means to “record transactions”?
Every business has to record all its financial transactions in a ledger otherwise known as bookkeeping. You’ll need to do this if you want to claim tax deductions at the end of the year. And you’ll need one central place to add up all your income and expenses (you’ll need this info to file your taxes).
Which Accounting Method Is the Best Choice for a Small Business?
For freelancers and small business owners, whether to choose the cash vs. accrual method of accounting comes down to considering the pros and cons. The cash method is an easy and familiar bookkeeping method for keeping track of your monthly income and expenses. However, it doesn’t give you a full view of your finances. And if you want your business to grow in the next few years, it would be a smart move to learn the accrual method.