Before you even make your first sale, it’s important to set up your financial accounts. One of the fundamental decisions for any small business to make is which accounting method to choose. Who can use cash basis accounting, and what are its benefits for small businesses? We’ll cover the advantages of cash accounting vs accrual accounting below.
What is cash accounting?
You can’t determine the best accounting method for your business without understanding the basics, so what is cash accounting? Cash basis accounting is simple, straightforward, and easy to get a grasp on even if you’re new to balancing the books.
With cash accounting, you’ll record income and expenses when they’re physically paid and received. Rather than dealing with Accounts Receivable and Accounts Payable, you’ll simply use cash accounts to record income and expenses. This means that each transaction only needs to be recorded once in a cash account using the single-entry bookkeeping method.
Cash accounting vs accrual accounting
Cash accounting uses a simple cash-in, cash-out process, but how does it measure up to accrual accounting? The accrual accounting method is slightly more complicated, using the double-entry bookkeeping system. Instead of recording income and expenses as they’re physically received, with accrual accounting you record them at the time of the transaction
For example, you might make a sale to a customer and issue an invoice on the 1st of September. Under the cash accounting method, you’d only record this transaction when the invoice has been paid and the cash has reached your account. Using accrual accounting, you’d record the transaction when the invoice was issued. It would be recorded in multiple accounts, including Accounts Receivable when the invoice is issued and your cash account when the invoice is paid.
Benefits of cash accounting
There are some distinct benefits to using cash accounting, particularly for smaller businesses.
Beginner-friendliness – You don’t need to be an accounting expert to get started with the cash basis. You simply record transactions when you pay an expense or get paid for a service. You won’t have as many accounts to keep track of, nor will you need to figure out the double-entry bookkeeping system.
Cash flow tracking – Another benefit to cash basis accounting is that it gives you a clear overview of how much cash you have on hand to work with. For small businesses and start-ups, this is very beneficial because it helps you manage expenses more easily. What you have in your cash account is what you have available to spend at any given point in time. By contrast, with the accrual basis you’d need to factor future payments and receivables into the equation.
Potential tax advantages – A third benefit for small businesses is that it can simplify your tax returns. You’re only responsible for recording income and expenses as they enter your account. This gives you some control over the timing of large payments, potentially reducing your tax burden for a given year. For example, if you know you’re owed a large payment from a client but it’s nearing the end of the tax year, you could postpone the payment until the new tax year has begun. This gives you a legal way to reduce tax liability by staggering payments.
Who can use cash basis accounting?
While many companies can use cash basis accounting, it makes more sense for small businesses and independent contractors. For all the reasons outlined above, using this method keeps the accounting process straightforward, simple, and beginner friendly.
The method isn’t as well suited to larger businesses, however. A disadvantage for growing companies is that the cash basis doesn’t show the bigger picture of income and expenses. For example, it leaves out liabilities which form an important part of a larger business’s bottom line.
There are also a few circumstances in which cash accounting isn’t allowed. For example, if you use inventory to account for your income, or sell services on credit, this method won’t work for your business. By offering credit, your customers buy now and pay later. This makes it impossible to accurately track your finances using cash accounts alone.
As you can see, there are many reasons to consider cash accounting. If you’re in any doubt, it’s always worth speaking to an accountant to choose the best framework for your small business.
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