Cash Basis vs. Accrual Basis Accounting: Which Is Better for Your Business?
When it comes to keeping track of expenses and income for your business, there are two primary methods of accounting: cash basis and accrual basis accounting. Knowing the differences between them is very important for small business owners, because the method you choose affects your business in a number of ways, including how you track cash flow and pay your taxes. Understanding which accounting method you should use will allow you to operate your business using the best bookkeeping practices.
Cash Basis Accounting
Cash basis accounting, while less common overall, is frequently used by small businesses. This approach centers around cash, only accounting for income and expenses when payment has changed hands. For example, if a client pays you with cash or check today, then you would record the payment. But if you make a sale today that won’t be paid until next month, you would not record the payment until you receive it. Similarly, whenever you get a bill, you wait to record the expense until you have actually paid it. Therefore, this method does not consider accounts receivable and payable.
Due to its simplicity and accurate portrayal of cash flow, many small business owners favor this method over accrual basis accounting. Often, there is little need for accounts receivable or payable, because tracking transactions is as straightforward as seeing if the money is in or out the bank. The cash method makes it easy to see exactly how much money you have to work with at any time, because all you have to do is look at your current bank balance, then subtract uncleared checks, and you’ll know how much money you have on hand. Also, because transactions aren’t logged until expenses are paid or income is received, your business’ income isn’t taxed until it’s actually deposited in the bank.
Each payment you are waiting to send or receive is not accounted for with cash basis accounting, which can lead to a distorted view of your company’s overall financial health. You may have a perfect idea of how much cash your company currently has, but if you aren’t tracking those unrecorded expenses, you may have less money to spend than what is currently in the bank. This method also makes it harder to match your income and expenses, because it can be difficult to tell if the bills you are paying after 30 days are related to the check you deposited yesterday.
Accrual Basis Accounting
By contrast, accrual basis accounting is the opposite of cash basis accounting. With this method, income is recorded when it is earned and expenses are recorded when they are incurred, regardless of when the money is actually received or paid. This means you can take revenue and expenses into account as soon as you know about them, even before any cash is exchanged.
The main benefit of this method is it provides you with an accurate view of your business’ income and expenses. It offers a clearer picture of your profitability, especially for larger businesses with more accounts receivable and payable. This is especially useful for analyzing your business’ finances in the long term. Even if your clients won’t be paying for your products or services yet, you can account for that revenue.
One potential downside of this approach is that it doesn’t show a business’ cash flow. You may have plenty of money coming in later but far less cash on hand in the present, which could lead to a cash crunch. To remedy this issue, you may want to prepare cash flow statements to supplement your accrual basis accounting. However, the need for additional financial statements can make this method more complex than cash basis accounting.
How to Choose: Cash vs. Accrual Accounting
When choosing an accounting method for your business, it can help to determine your priorities for using the information each method provides. Depending on what is most important to you, you may choose cash basis accounting for its simplicity or accrual basis accounting for a deeper understanding of your business’ financial picture.
If you need help navigating the complexities of choosing an accounting method for your business, or if you need any other bookkeeping or financial guidance, pick up the phone and call the experts at Tower Books today. You can reach us at (757) 512-8742 or send us an email at email@example.com.