You’ve taken your first steps into business, but are still unsure about how you are going to handle your business’ accounting. Accounting is an all-important process that steers your business forward and helps you gauge your success. Before you start, you need to decide on the accounting method you’re going to use for your business. There are two methods of accounting: cash-based and accrual-based.
What makes choosing the right method important?
The method you use for your accounting influences your business in many ways:
- Revenue is recognized differently in each method. You need to be sure that the method you choose suits the way you want to calculate revenue for your company.
- Both methods offer different financial reports that affect the way you determine the financial position of your company, and make business decisions for the future. You need to choose the method that offers the right financial reports for your business.
- The method you choose influences how you file taxes and claim tax deductions. This is because the cash and accrual methods report taxes at different periods depending on when revenue is earned. You need to choose the method that works best for you during tax season.
Let’s take a peek into what the two accounting methods are and how they work.
Cash-based accounting
As the name suggests, the underlying factor in cash based accounting is cash itself. It is the simpler of the two methods. Here, transactions are recorded whenever you receive cash payments from customers, or whenever cash leaves your company in the form of expenses or vendor payments.
Let’s look at an example that illustrates this method with a sales and a purchase transaction.
Sales transaction:
-
Suppose you’re a carpet retailer, and you sell carpets worth $100 to a client on the 1st of July, and your client makes a cash payment on the 5th of July.
-
In cash accounting, you record the sales transaction on the 5th of July (when you receive the cash).
Purchase transaction:
-
You buy carpets from your vendor for $100 on the 10th of June. For this purchase, you make cash payment only on the 6th of July.
-
Here, you record the purchase transaction on the 6th of July (when you pay cash).
The pros and cons of cash accounting
Pros
Cash accounting is simple offers many advantages to very small businesses that operate purely on a cash basis.
-
It doesn’t require you to have vast accounting knowledge and its simplicity allows you to maintain your accounts without having to hire an accountant.
-
It also doesn’t require accounting software, because you can accomplish accounting tasks with a simple cash book, or with spreadsheet software.
-
The most important advantage of this method is that it records your transactions purely in terms of cash inflows and outflows. This provides an accurate picture of how much money there is in your company at any given time.
Cons
Although it’s simple to implement and provides accurate insights about your cash flow, cash accounting has a few downsides.
-
Companies that account on the basis of cash don’t usually employ an integrated accounting system. This can increase the chance of errors, as there is no built-in error-checking mechanism.
-
While it shows you how much money you have, it doesn’t show you your financial position. This is because cash accounting doesn’t make it easy to generate reports like income statements and balance sheets that are necessary to determine your financial position accurately.
When do you use cash accounting?
Cash-based accounting is usually used by very small businesses. You might follow the cash basis of accounting if:
-
Your business is very small, held by sole proprietorship or privately.
-
You do not sell on credit, i.e., you do not provide goods without immediate payment and invoice customers later.
-
You use a single-entry accounting system.
-
You have only a few employees working in your company, and a cash accounting setup is enough to handle employee salaries and reimbursements.
-
You have relatively few transactions each day and they can be recorded in a cash book or a spreadsheet.
-
You do not own many physical assets and tracking inventory for them isn’t necessary.
Accrual-based accounting
In accrual-based accounting, transactions are recorded not when cash comes in or goes out, but when they are initiated. With this system, you record revenue when you earn it, and expenses when you incur them, irrespective of when the payment is made.
Let’s take the same example as above, but apply the accrual-based method.
Sales transaction:
-
You sell carpets worth $100 to your client on the 1st of July and your client makes payment on the 5th of July.
-
The difference in accrual based accounting is that you record the sales transaction on the 1st of July (when you sell the carpets)
Purchase transaction:
-
You buy carpets from your vendor for $100 on the 10th of June. But, you make payment on the 6th of July.
-
Here, you record the purchase transaction on the 10th of June itself (when you buy the carpets)
The pros and cons of accrual accounting
Pros
Accrual-based accounting is the more widely used of the two methods and is used by all large companies.
-
Accrual accounting is suited for businesses that sell on credit. You can record transactions and keep track of invoices even if you haven’t received the cash for them.
-
You record transactions in the accrual method when they’re initiated. This makes it easy to track what you owe vendors and what your clients owe you at any time.
-
You can get a better picture of your financial position through this method. The accrual basis allows you to create financial reports like balance sheets and income statements, that are key to know where your business stands.
Cons
The accrual basis for accounting suffers from disadvantages too.
-
It is not suited for efficient cash flow management. Since transactions aren’t recorded at the same time that cash is transferred, it is cumbersome to know how much cash you have in hand at a given time.
-
You need to use double-entry accounting if you follow the accrual basis. This makes things more complicated, as every transaction has to be recorded under a minimum of two accounts. This goes beyond the scope of a cash book, so it creates dependence on accounting software as well as an accountant.
When do you use accrual accounting?
The accrual basis for accounting is suitable when:
-
Your business is large, and you generate financial reports like balance sheets and income statements to track your financial position and performance.
-
You extend credit to your customers and let them pay you later from an invoice.
-
You use a double-entry system where transactions are recorded under at least two accounts.
-
You have many employees.
-
You deal with relatively large numbers of financial transactions on a daily basis, and you use accounting software rather than a cash book or spreadsheet.
Knowing the difference is key
Choosing an accounting method for your business comes down to the type of business you have. Both methods have their benefits. Cash accounting provides a beautiful understanding of your cash flow and is helpful for very small businesses. The accrual method is better for larger businesses and shows the company’s financial position more thoroughly through informative reports. Before you decide on either method for your business, compare the two methods and understand the differences between them so you can find the one that’s the best fit for you.