When does your business record revenue and expenses? It’s all about timing when choosing between cash vs. accrual accounting methods. We’ll take a closer look at the cash and accrual basis of accounting below, so you can decide which method is more beneficial.
What is cash basis accounting?
With the cash basis of accounting, you only recognize revenue and expenses when money is exchanged. For example, you might send out an invoice to a client on February 1st. However, the client doesn’t pay the invoice until the end of the month. Using the cash basis of accounting, you wouldn’t record this income until the invoice is paid.
It’s important to note that cash basis accounting doesn’t have to involve physical cash payments; it merely records income and expenses when accounts are settled with a payment. The payment could be electronic, and this would still qualify.
There are several benefits to using cash accounting, particularly for small businesses.
It lets you know exactly how much money is in your accounts.
It’s simple and straightforward.
It’s easier for tax calculations, since you base income and expenses on what’s actually in your accounts.
However, cash basis accounting can also be misleading from a financial perspective. Your business might look more profitable on paper than it is, simply because you haven’t yet paid your bills.
What is the accrual basis of accounting?
With the accrual method of accounting, income is recognized as soon as an invoice is raised. Expenses are also recorded as soon as a bill arrives, regardless of when you end up settling these accounts. As with cash accounting, there are certain benefits to accrual accounting.
You gain a more accurate perspective of your business’s finances.
Accrual accounting offers a better long-term view of performance.
You can plan ahead more easily.
Accrual accounting conforms to the Generally Accepted Accounting Principles (GAAP).
Yet as with the cash method of accounting, there are some cons to accrual accounting. For example, due to the unpredictability of payments, you might end up paying tax on revenue that you haven’t yet received. You need to keep a closer eye on invoices and bills, rather than simply basing financial decisions on what’s in your bank accounts.
Cash vs accrual accounting
As you can see, there are pros and cons to both accounting methods. The best option depends on your business size and operations. If you’re interested in growing your business and sourcing new funding, accrual accounting tends to be a better option. Investors prefer to see books prepared using the accrual method, because this shows you when your income and expenses are incurred. This makes it more accurate to compare month-on-month growth.
For smaller businesses or those who like to keep their accounting simple, the cash method of accounting might be better. It’s easier to keep accounts organized for tax purposes. However, keep in mind that with accounting software, it’s already quite simple to stay organized whether you use cash or accrual.
The IRS does require that companies making more than $25 million in gross annual sales use the accrual basis of accounting for auditing purposes. For consistency, once you choose an accounting method for the tax year, you need to stick to it. While you can always switch from cash to accrual next year, you can’t switch halfway through.
The best of both worlds
If you’re finding it hard to choose between cash vs. accrual accounting, you might be wondering if there’s a way to combine the two. Hybrid accounting systems might be preferable if your business is small. A business that uses both cash and accrual accounting might use the cash method for everyday transactions, and accrual accounting for inventory and bigger decisions like loans.
However, it’s important to note that using both cash and accrual methods can make your tax situation more complicated. You should consult with an accountant to find out how to keep your methods above board and organized.
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