Which Accounting Method Is Best For Your Business? Cash or Accrual Method?
Starting a small business or a startup requires you to be versatile and conversant with everything from sales and marketing to accounting and tax laws. You do not want to mess with the Internal Revenue Service (IRS), as this could end up in hefty fines for not filing your business returns properly. The good news is that this article will help you know which accounting method will best suit your purposes. In this way, you will be better prepared to meet the competition and serve your market efficiently and effectively. So without further ado, let's begin.
There are two well known, and perhaps most important, methods of accounting that small business owners use. These are the Cash Method and the Accrual Method of Accounting. Why do we say, small business owners? Because of larger companies crossing annual revenue of $5 million are obliged to use the Accrual Method of Accounting.
Let's start with more commonly used one, The Cash Method of Accounting.
The Cash Method of Accounting
The Cash Method of Accounting happens to be the most popular way of accounting for small businesses, startups, freelancers and other minor entities. This is due to the fact that in the Cash Method of Accounting, you will only record incomes or expenses when cash actually changes hands, and not one minute before this happens. For example, if you have just started a computer installation business and you get a job in November but get paid three months later in January, you will record your income in the month of January and not November. As you will see later, in the Accrual Method, you would have recorded your income in November and not in January.
Cash Method of Accounting, as defined by the financial-dictionary.thefreedictionary.com, is A system of accounting that recognizes revenue and expenses in the order in which they are received or made.
Let's look at a few examples to put things into perspective.
- Company A receives a bill for the building of office furniture. Using Cash Method Accounting that transaction becomes recorded when the company pays that bill.
- Company A receives a bill from Utility of $800 on September 18th,
- Company A pays the bill from Utility of $800 on November 3rd,
- The cash transaction of $800 is recorded on November 3rd, and not September 18th, since the Utility was paid in November.
- Company A sends a bill to the client for creating a business plan. Using the Cash Method Accounting the transaction becomes recorded when the client pays that bill.
- Company A sends a bill of $300 to Client B on January 28th,
- Client B pays the bill of $300 on March 5th,
- The cash transaction is recorded on March 5th and not on January 28th since Client B paid the bill in March.
Important Notes About The Cash Method of Accounting
There are a few things that you need to know if you will be using the Cash Method of Accounting:
- You will need to be conversant with the differences between the calendar tax year versus fiscal tax year reporting on the gov website.
- It is not possible for you to delay reporting any income received by holding on to checks received in one year and pushing them forward to the next year. You must always declare income when you receive it to avoid running afoul of the Internal Revenue Service.
- It is crucial to note that the Internal Revenue Service prohibits some businesses (those grossing more than 5 million USD) from using the cash method of accounting. There are also special rules for farming businesses. You can access this information here.
Advantages And Disadvantages of The Cash Method of Accounting
- You will enjoy accurate tracking of your cash flow. This is because the cash method of accounting only records income when your business receives the money and records expenses only when your business disburses the money. As such, you will have a better picture of how much money your business actually has at any given moment in time.
- There will be less bookkeeping involved since accounting records are only made when cash actually enters or leaves your business account.
- The disadvantage of the Cash Method of Accounting is that there will be an inaccurate representation of long term revenue and expenses. For example, if your business seals a lucrative business deal with another company in 2015, but payment is actually made in 2016, there will be a false impression that business was booming in 2016, when in fact you were only recording cash earned the previous year. It is also possible for your business to start reflecting negative cash flow even though you are expecting additional revenue from your debtors.
The Accrual Method of Accounting
The Accrual Method of Accounting is different from the Cash Method of Accounting in that the income is recorded immediately the sale is done, even if you do not see the money right away. The same applies to expenses, seeing that they are recorded when goods or services are received, and not when they are paid for.
The Accrual Method of Accounting is preferred by businesses which want to have a clear picture of the ebbs and flows of business throughout the course of the fiscal year. This is probably due to the fact that the accrual method of accounting is quite good at matching revenues to expenses. However, you may be left in the dark when it comes to estimating the cash flow that your business has. This might leave you in dire straits if you find out that your business has made a lot of money on paper but actually has close to nothing in hard cash in the bank.
The Accrual Method of Accounting, as defined by the accountingcoach.com, “refers to adjustments that must be made before a company's financial statements are issued.”
Let's look at a few examples to put things into perspective.
- Company A receives an invoice for rent from their landlord. Using the Accrual Method transaction becomes recorded when the bill is received.
- Company A receives a rental bill of $1,000 on June 20th,
- Company A pays the rental bill of $1,000 on August 12th,
- The accrual transaction is recorded on June 20th, and not August 12th, even if it was paid for in August.
- Company A sends a bill to the client for website creation. Using the Accrual Method Accounting the transaction becomes recorded when the bill is sent out.
- Company A sends a bill to Client B of $600 on April 4th,
- Client B pays the bill of $600 on July 16th,
- The accrual transaction is recorded for April 4th, and not July 16th since Client B received the bill in April.
Important Notes About The Accrual Method of Accounting
- If payment has been made in advance for services that will be completed in the next accounting year, then you can delay paying tax on that income until the next tax year. However, you cannot postpone paying tax further than the period stated by the IRS.
- If you have paid for an expense in advance, you can only deduct it from your tax burden in the year that the expense occurred. You can read the IRS publications to uncover any exceptions to this rule here.
Advantages And Disadvantages of The Accrual Method of Accounting
- You will enjoy accurate tracking of your revenues and expenses during the accounting year. It will be easy for you to find out how much your business has earned and how much it has incurred in expenses.
- There will be a problem in the inaccurate representation of your cash flow. This means that you have to be vigilant to prevent operating your business on a negative cash flow.
- There will also be more bookkeeping involved for you, seeing that you will need to record both the transaction date of the sale and the date of received payment.
As a young startup, you might want to start with the Cash Method of Accounting so as to have an accurate picture of your cash flow, and most importantly, so you are not forced to pay taxes from income that will be due next year. This is an enormous factor of importance for starting companies, freelancers and for businesses that don't have established revenue streams, as these can be very easily strapped for cash, yet would be due to pay taxes from the cash they don't have.
Since the IRS accepts both types of accounting, you have the chance to choose the method of accounting that you are most comfortable with. As your business matures, you will want to include the Accrual Method of Accounting for business analysis purposes. In fact, many businesses end up incorporating a Hybrid Method of Accounting that features both cash and accrual methods of accounting.
Learn more about Hybrid Method of Accounting in our detailed Business Owner's Guide To Accounting Methods.