As the owner of a new small business that is in the process of setting up its accounts, you need to make a decision as to which method of accounting you will use to manage the financial aspects of your company: cash accounting vs accrual accounting.
Both cash accounting and accrual accounting are techniques of bookkeeping that can be useful for a variety of businesses, fields, and circumstances. In cash accounting, revenues and expenses are recorded whenever there is a transfer of cash. Revenue and costs are recorded in an accrual accounting system as soon as they are incurred. The hybrid approach combines aspects of both of these approaches.
The timing of when income and expenses are recorded is the primary factor that differentiates cash accounting from accrual accounting. The cash approach prioritizes the immediate recognition of revenue and expenses, whereas the accrual method places more importance on the estimation of future revenue and expenditures.
“The timing of when income and expenses are recorded is the primary factor that differentiates cash accounting from accrual accounting.”
Cash accounting and accrual accounting are two different approaches to financial reporting and each has its own advantages and disadvantages.
According to this approach, revenue is not included on the income statement until after cash has been collected from customers. Only when cash is actually spent are expenses entered into the accounting system. The cash accounting technique is most frequently employed in the financial dealings of private individuals and in the operations of small businesses.
When using this method, revenue is recorded into the books as soon as it is earned. The accrual method of keeping financial records differs from the cash method in that it recognizes revenue upon the delivery of a good or service to a client on the understanding that payment will occur at a later date. In other words, proper accounting is performed prior to the receipt of monetary funds. In a similar manner, spending for both products and services are documented prior to any cash being exchanged for said expenditures.
The simplicity of cash accounting is its primary benefit; this method merely takes into account cash that is paid or received. Keeping tabs on a company’s financial flow is also made much simpler. It is advantageous to sole proprietorships and other types of small enterprises because, in most cases, using it will not need the hiring of additional staff (and the associated costs).
However, the cash basis method has the potential to overestimate the health of a business that has a large amount of cash on hand. This is due to the fact that it does not record accounts payables that could potentially exceed the cash that is currently on the books as well as the present income stream of the organization. As a consequence, an investor may come to the incorrect conclusion that the firm is earning a profit when, in fact, the company may be having trouble meeting its financial obligations.
On the other hand, accrual accounting keeps record of accounts receivable and payable and, as a result, is able to present an accurate picture of a company’s profitability, especially over the course of a longer period of time. For instance, if a corporation keeps its financial records according to the cash method of accounting, the revenues from the most recent quarter won’t be reflected in the financial statements of the organization. It is anticipated that the comparable revenue will be included in the succeeding quarter. It is possible for an investor to form the incorrect impression that the company is not profitable when, in reality, the company is doing rather well.
The accrual technique does not have a cash flow tracking component. A business could appear to be profitable over the course of several years, but in reality, it may be struggling with a significant cash shortage in the short term.
It is possible that utilizing the accrual method, which requires users to account for things like unearned revenue and prepaid expenses, requires users to have a higher level of accounting expertise, which is another one of the technique’s downsides. There is also a chance that the business will require the services of additional employees.
The accrual method is acknowledged as compliant with the generally accepted accounting principles (GAAP). It is frequently required of businesses that submit their financial statements to be audited, whereas the cash basis method is not acceptable under GAAP. The generally accepted accounting principles (GAAP) were established by the FASB.
Let’s imagine you run a company that offers several types of machinery. In accordance with the cash method of keeping records, the transaction for the sale of $5,000 worth of machinery will not be entered into the books until either the customer turns you the cash or the check is presented to you.
Even though you might not get the money for a few days, weeks, or even months after the sale was made, the $5,000 will still be recorded as income according to the accrual method as of the day the transaction was made.
The same guiding idea applies to financial outlays. Under the cash method, the sum will not be recorded if the firm receives a bill for electric service in the amount of $1,700 before the time that the company actually pays the bill. On the other hand, according to the accrual system, the $1,700 is counted as an expense on the same day that the company is billed for it.
Fortunately, for cash accounting, there is a plethora of software and other tools available to help businesses of all sizes keep their financial records in excellent condition, relieving them from the need to do it manually. There are bookkeeping services and software alternatives available that are designed to perform most effectively with accounting on a cash basis.
FreshBooks is a cloud-based accounting software application that offers reasonable pricing tiers to cater to the needs of small businesses and independent contractors. It enables you to issue invoices and take payments in a very short amount of time. FreshBooks provides all the fundamentals while maintaining a straightforward and user-friendly interface.
When your company grows in size and complexity, you should be more willing to make the switch to accounting software and services that are compatible with accrual accounting. For instance, you can move from using cash accounting to using accrual accounting with Intuit’s QuickBooks Online. You can keep track of things like invoices, spending, staff hours, and more using this application that requires a membership. If you work with an accountant, it will be simple to share your spreadsheets so that you can get an accurate picture of your financial situation and your legal responsibilities regarding taxes.
Accrual-based accounting is the only method that should be used if you either manage inventory or have an annual revenue of more than $5 million. Accounting on an accrual basis is the system that is more sophisticated, but it also yields more accurate results. You should absolutely educate yourself with the procedure, but you can leave a lot of the technical intricacies up to your program. This is because the majority of accounting software defaults to using it anyhow.
If you are in the business of selling services as opposed to tangible items, you may have the option of selecting any of these two approaches. During the initial setup of accounting software such as Xero and QuickBooks Online, you are given the option to select the accounting system that best suits your needs.
Make an informed decision on the method of accounting you will use because it will have a significant impact on your books for a considerable amount of time regardless of which approach you take.
Cash accounting vs accrual accounting, which one should you be using?
The majority of freelancers and small enterprises use the cash accounting method as their primary system of record keeping. Accrual accounting is the method utilized by the most majority of other businesses, particularly those of a medium and large size.
Some owners of businesses have the ability to choose and select the form of accounting that they want to utilize, while others do not. Accrual accounting is required if, among other things, you keep track of inventories or offer your customers the option to make purchases on credit. Accounting on an accrual basis is another requirement for C businesses.
Accrual accounting is the method that should be utilized by the vast majority of businesses. It has a higher degree of precision, and the Internal Revenue Service mandates that you make use of it if you are responsible for managing inventories. If you keep your books on a cash basis, you won’t be required to record any financial transactions until the cash actually leaves or enters your bank account. When you use accounting on an accrual basis, you will record transactions as soon as you send an invoice or receive a bill rather than when the money actually changes (virtual) hands. This is in contrast to traditional accounting, which records transactions only when the money is physically transferred. Examine the following list of bookkeeping techniques, learn the benefits and drawbacks associated with each one, and then select the approach that best suits your needs.
In order to determine which type of accounting will work best for your company, you will need to evaluate your operations in light of the guidelines for accounting established by the IRS.