There are two primary accounting methods that dictate the day-to-day bookkeeping processes in your business. They are Accrual Accounting and Cash Basis Accounting. We’ll talk about the pros and cons of each of these methods, but for now, just know that you’ll want to choose one and stick with it.
Okay, let’s break these two accounting systems down and find out which one is right for your business. Sound good?
According to Investopedia: “Accrual accounting is a financial accounting method that allows a company to record revenue before receiving payment for goods or services sold or expenses are recorded as incurred before the company has paid for them.”
Simply put, if your business uses the Accrual Accounting Method, you record income when it is earned (i.e. when you send an invoice to a client), and you record expenses when they are billed, even if you don’t actually pay the bill until later.
Examples of Accrual Accounting:
- A website design business invoices a client for 10,000 on August 15th, but receives payment for that invoice on September 2nd. Since this company uses Accrual Accounting, the $10,000 would be included in the income for the month of August even though the money cleared the bank in September.
- By the same token, the same web design business buys a new desktop computer on credit in November, and begins making payments on it starting in December. According to Accrual Accounting, the expense would be recorded in November’s ledger.
Accrual Accounting gives you a good long-term picture of your business’s financial health. However, because this method of accounting does not take into account what’s actually in your bank account, you need to track your cash flow in addition to your day-to-day bookkeeping.
Accrual Accounting is required by the IRS of any business that makes more than $25 million in annual revenue. If your business is ready to scale to that level or is primarily inventory-based, we would recommend choosing this accounting method.
Cash Basis Accounting
The opposite of Accrual Accounting, Cash Basis Accounting records transactions when they actually clear the bank. This method is pretty straightforward and easy to get the hang of.
For example, the website design business previously mentioned that received payment in September for a service provided in August would record the income for the month of September. And likewise, the same business would record the payments made for the desktop computer when the money actually left the bank.
Cash Basis Accounting is simple and gives you a better understanding of your business’s immediate financial health. This method of accounting could be right for you if your business is small and you are handling your finances yourself. Additionally, if your bookkeeping is done on a month-by-month basis, the Cash Basis method would probably be the better option for you.
Comparing Accrual vs. Cash Basis: Pros & Cons
||Accrual Accounting gives a good long-term picture of your business’s finances. This overview can help you make better business decisions in the future based on how your business performed in the past.
||Accrual Accounting is definitely more complex than Cash Basis Accounting. It requires more paperwork and also requires you to keep track of more accounts like Accounts Receivable and Accounts Payable.
||This method of accounting is scalable. If you’re wanting to significantly increase your business’s revenue (even before you hit that $25 million mark), Accrual Accounting will grow with your business.
||Because this method of accounting doesn’t let you see the immediate “right now” picture of your business’s finances (What your statement says probably won’t match your bank account.), additional steps are required in order to manage your business’s cash flow.
||Cash Basis Accounting is simple and easy to implement and maintain. Especially if you are handling your own bookkeeping and are just getting started, this method requires less upkeep than the alternative.
||Cash Basis Accounting doesn’t give you a good long-term view of your business’s finances. Your view of how much you made and spent in a month could be skewed if you didn’t receive payment until the next month or made payments over a period of time.
||Cash Basis Accounting makes paying taxes easier and potentially less burdensome. Because you record income when it actually hits your account, you will only ever pay taxes on money that you actually have, whereas if you choose to use Accrual Accounting, you may be taxed on income that you have not received payment for yet.
||Cash Basis Accounting is great while your business is small and your bookkeeping is pretty low-maintenance, but it becomes difficult to scale while maintaining this accounting method. It is possible to switch accounting methods once you begin to grow, but that can be an involved and burdensome process.
Here’s the Bottom Line
Whether you choose Accrual or Cash Basis Accounting, pick one and stick with it unless it becomes necessary to switch.
Not sure which system is right for your business? We can help! Get advice from an accounting expert. We’ll not only help you know which method is right for you, but we’ll also walk you through setting up your preferred accounting system in QuickBooks.