There are two ways to track your business’s money, the cash method and the accrual method. In order to keep accurate records, it is important to follow one regularly. Each basis has its pros and cons. Some businesses run better on a cash basis, other on accrual. In order to understand which is best lets first dive into what each accounting method is.
Cash Method
Cash basis accounting refers to the method of recording transactions once money is received or paid. This means that income and expenses are not recorded at the time they are incurred but at the time the money is physically transferred. This accounting method is not right for every business but can bring simplicity to those that it does work for. With this method the company has an accurate picture of cash on hand but financial reports may be misleading.
Accrual Method
With Accrual basis accounting we do the opposite. Transactions are recorded when revenue or expenses are incurred not at the exchange of currency. This process requires a few more steps including frequent use of accounts payable and accounts receivable. These accounts help the company keep track of what money is owed to or by the company. For this method, the sale is recorded before money is received so the sale is moved into accounts receivable to keep track of its status. Once the invoice is paid the amount is moved from accounts receivable to cash to reflect the company’s increase of cash on hand.
Using the Cash Method
Cash accounting is best for small businesses without inventory. Cash accounting is a simple way to keep track of your books. This empowers small business owners to do their own bookkeeping. The simplicity or subsequently low cost makes this a great choice for businesses just starting out. For larger companies, it is not recommended to use the cash method and there are some restrictions preventing certain companies from using it.
Using the Accrual Method
Accrual based accounting can be intimidating especially compared to the cash method but don’t let it scare you away. The accrual method is the preferred accounting method for most businesses. The accrual method should be used by medium to large businesses, businesses planning to scale to that size, or businesses of any size that hold inventory. However, it is effective for all businesses including small ones just starting out. Accrual based accounting gives an accurate representation of the business’s operations. Under this method, reports will show total sales, total unreceived payments and even overdue payments that the company may be able to write off as bad debt. While it takes a little more time to understand the inner workings of accrual accounting and how to interpret the reports, it is worth it in the end.
Summary
Each accounting system has its advantages and disadvantages. With cash accounting, we have a simple process that can be easy to use and understand making it great for small businesses or those just starting out. However, the cash method gives a clear idea of cash on hand, but the business’s activity can be misleading. Accrual based accounting is undeniably more complex than cash based accounting. Although it can be harder to learn, it is a wonderful choice that suits many businesses and provides financial clarity.
Both accounting systems can be beneficial depending on your company’s needs. For those able to use the cash method, it can provide ease of use while the accrual method can adapt and grow with any business. The important thing is to consider your business’s needs and make an informed decision. If you would like help deciding which accounting principle is best for you contact me to schedule a free consultation.
Arrowhead Financial 