Precise accounting is a critical component of running a successful business. There are two primary accounting methods you can use as a small business owner: cash and accrual accounting. Even if you don’t handle your own accounting and bookkeeping tasks, it’s vital to know how each of these accounting methods works so you can choose the correct bookkeeping practices for your company.
With the cash accounting method, you record your income and expenses as you receive and pay them. For instance, if you invoice a customer for $5,000 on April 1 and receive the actual payment on May 15, you would record that income as received for May — when you actually had the cash in hand.
Also, note that the cash accounting method doesn’t consider accounts receivable or payable. It only applies to payments that have been received from customers via cash, debit, credit card, or check.
Likewise, cash accounting only records expenses when money actually leaves your account to pay to vendors, suppliers, or other third parties. For example, if you purchased paper supplies on credit in April but didn’t pay the bill until May, you would record those supplies under May expenses.
Cash accounting is often the preferred option for businesses that make less than $25 million in annual sales or don’t sell merchandise directly to consumers. It’s a favorite choice for many small businesses, such as partnerships and sole proprietorships.
Advantages of Cash Accounting
- Simplified process
- Improved cash flow by deferring income taxes
Disadvantages of Cash Accounting
- Inaccurate financial picture
- Lack of accounts receivable or accounts payable records
- Doesn’t align with the Generally Accepted Accounting Principles (GAAP)
Accrual Accounting Method
Accrual accounting is the method that meets the accounting standards outlined by GAAP. Handling financial reporting with accrual accounting provides a clearer picture of your company’s overall finances.
With the accrual accounting method, you record income and expenses when they’re billed and earned, without considering when the money is received. For example, if you bill $5,000 in income on April 1, you would record that $5,000 as income in your April bookkeeping even if you didn’t receive the funds in your account until May 15.
The same holds true for expenses. So, if you purchased paper supplies on credit in April but didn’t pay the bill until May, you would still record those supplies under April expenses.
Advantages of Accrual Accounting
- Provides a more accurate financial picture
- Conforms to GAAP
Disadvantages of Accrual Accounting
- More resource-intensive
- Inaccurate short-term view
Which Accounting Option is Right for Your Business?
The accounting method you choose for your business is ultimately a management decision, but it also depends on the resources you have, your business goals, and your organization’s financial requirements. If your company makes less than $25 million in gross annual sales, you can adopt whichever method makes better sense for you. But keep in mind that the IRS requires businesses to maintain the same accounting method for reporting taxable income for a full year — no changing in the middle of the tax year. If you’re unsure of the right accounting method to use for your small business, consult with a CPA or tax professional.