Mention the word “accounting,” and most people cringe. Whether it’s the thought of crunching numbers or keeping financial books, accounting often catches a bad rap.
However, the method you choose will have a critical impact on how you conduct business moving forward. How so? Depending on whether you complete sales on cash or credit or what your business structure, your accounting method must follow suit.
The two most popular choices are the cash basis accounting method and the accrual accounting method.
Businessdictionary.com defines the cash basis accounting method as an accounting method in which income is recorded when cash is received and expenses are recorded when cash is paid out.
Some key differences of a cash basis method are:
- It is the simplest option because it only accounts for cash flow. This can be problematic, however, in that the method may not portray an accurate representation of long-term profitability.
- Small businesses can benefit from using this method because expenses are not accounted for until that service is paid off.
- A major benefit of using the cash basis method is that you do not pay income taxes on revenue until it is received, as opposed to the accrual method.
The accrual accounting method is defined by businessdictionary.com as a system of accounting based on the accrual principal, under which revenue is recognized and recorded when earned, and expenses are recognized when incurred.
The fact that this method recognizes expenses as soon as the service is completed, even if payment is not yet received, making the accrual basis method more complicated than its cash basis counterpart.
The accrual basis method varies vastly from the cash basis accounting method, but here are some of the more noteworthy differences:
- Revenue and expenses are recorded as they take place instead of when payment is received. This can be thought of as buying something on credit. Although the payment is not made until after the fact, revenue is recognized at the time of the transaction.
- If your business sells on credit or has inventory, the accrual basis method should be used.
After breaking down the details of the methods, you may find it easier to decide which works best for you. The cash basis accounting method does favor small businesses and start-ups because of its simplicity, however consider the following questions before choosing between the accrual and cash basis methods.
- What is your business structure like?
- Does your company hold inventory?
- Is your sales volume geared towards cash or credit?
Although it may be tempting to put accounting decisions on the back burner, the accounting method you use impacts your business as a whole and any decisions moving forward.