As a small business owner, you may be passionate about all aspects of developing your business, but it may not include accounting. There are two primary methods to recognize expenses you need to know: cash and accrual accounting methods. Even if you don’t work as an accountant, it is essential to know how each one works so you can choose the best bookkeeping practice for your business.
Let’s take a look at both methods in detail, and how each one would affect your business.
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What is the cash accounting method?
In the cash accounting method, you record income as it’s received and expenses as they’re paid. For example, if you invoice a client for $2,000 on August 1st and receive payment on December 5th, you would record the income as received for the month of December.
Because this method is easy to determine when a transaction occurs, mostly small businesses and personal finances are preferred to use it.
What is the accrual accounting method?
Accrual accounting is an accounting method of recording revenue and expenses when they’re billed and earned, regardless of when the money is actually received. For example, if you bill a client $2,00 on August 1st, you would record income on August 1st despite not receiving the money yet.
Unlike the cash method, the accrual accounting records revenue as soon as a product or service is delivered to a client with the expectation that money would be paid in the future. The same holds true for expenses, you record expenses of goods or services despite no cash being paid out yet.
The key difference between cash and accrual accounting
The key difference between cash and accrual accounting lies in the timing of when revenue and expenses are recognized. The accrual method recognizes revenue and expenses when they occur, while the cash basis method won’t record until cash exchanges hands.
What are the advantages of cash accounting?
The key advantage of cash accounting is simplicity.
As mentioned, many small business owners choose the cash method of construction accounting because it’s a simplified bookkeeping process. Because the cash method only accounts for cash paid or received, it’s easier to track the cash flow of a company. There’s no need to record receivables and payable, that allows you to see quickly how money goes in and out of bank accounts.
If your business does not have large inventories of products and you exchange primarily through cash transactions, the cash accounting method can be a convenient and reliable way to keep tabs on revenue and expenses without the need for a great deal of bookkeeping.
When it comes to taxes, the cash accounting method offers definite perks. For instance, you invoice a client for $2,000 in December, but you might ask your client to hold payment until next January. Accordingly, you are effectively delaying that money to report a lower profit and pay lower taxes for the current year.
Read More: How to Calculate Cash Flow
What are the disadvantages of cash accounting?
While the cash method of accounting is simple and straightforward to maintain, it has its drawbacks as well.
No accounts receivable or accounts payable records - Inaccurate financial picture
Since it doesn’t account for all incoming revenue or outgoing expenses, the cash method might overstate the health of a company that is cash-rich but has large sums of accounts payables that far exceed the cash on the books and the company's current revenue stream.
What are the advantages of accrual accounting?
In contrast to the cash accounting method, accrual accounting includes accounts receivables and payables. As a result, it provides a more accurate picture of the profitability of a company, particularly in a long run. It also allows your account to plan better for peak months of operation.
What are the disadvantages of accrual accounting?
Although accrual accounting is a more complex method of bookkeeping, it is likely to provide an inaccurate portrayal of a company’s short-term financial situation. Because it doesn’t track cash flow, and might not account for a company with a major cash shortage in the short term. In other words, you are less aware of cash flow, your business can appear to be very profitable while in reality, it has simply bank accounts.
Choosing the right accounting method for your business
Both methods have their advantages and disadvantages, and each one shows you a particular aspect of the financial health of your company. How to choose the right accounting method depends on your business goals, the resources you have available, and your organization’s financial requirements.