Cash vs Accrual Accounting
You have finally taken the leap and started the business you have always dreamt about. However, now you must make one more tough decision: what accounting method should your business follow: cash or accrual accounting? Accounting methods are rules and guidelines that a business uses in reporting revenues and expenses. The two most common methods are the cash method and the accrual method. It is important to use the accounting method that best fits your business because of the impact it has. For instance, how your business reports revenues and expenses can impact the ability to secure a business loan. Having an understanding of each method will help you to choose the best accounting method for your business.
The cash accounting method, also known as cash basis, is the most simplistic of all the methods. It is also the more commonly used accounting method. Under the cash accounting method, a business reports revenues when it receives income, and reports expenses when it pays bills. The cash accounting method is best for smaller businesses or sole proprietorships, with no inventory.
Businesses choose to use the cash accounting method because of its simplicity. It is similar to how an individual may track their personal finances. With this accounting method, a business can see exactly how much cash it has at any given point in time. Another benefit of cash accounting is that the implementation of it is much easier. The largest disadvantage of this accounting method is that it does not show the “real picture” of your business.
Under the accrual accounting method, as a business earns its revenue, it recognizes it. A business recognizes expenses when a transaction occurs, regardless if invoicing occurred. The purpose of this accounting method is to match income and expenses in the correct year. The IRS requires businesses to use the accrual accounting method if they meet certain criteria. A business that chooses to follow Generally Accepted Accounting Principles (GAAP) is also required to use the accrual accounting method.
The complexity of accrual accounting is what allows a more accurate representation of a business’ true financial position. Of the two methods, accrual accounting shows the most accurate picture of overall cash flow. The accuracy accrual accounting provides, also allows for better analysis of the business. However, the complexity of this method is a double-edged sword. Accrual accounting is more difficult and costly to implement, and can lead to deception in financial reporting.
Accounting methods should align with a business’ needs. Taking the time to learn about each method, including their advantages and disadvantages, will help in making a decision. However, nothing beats having the guidance of an experienced CPA to help ensure your business makes the best decisions.
Contributed by Elizabeth Partlow