As a small business owner, you regularly make decisions directly affecting your finances and taxes. One of your most important decisions is choosing the right accounting method for your business: accrual or cash. Both methods have advantages and disadvantages. The best one for you depends on your business type, size, goals, and preferences.
What is Accrual Accounting?
The accrual method of accounting records revenues and expenses as they are incurred, not when cash is exchanged. For example, if you sell a product or service on credit, you record the revenue when you make the sale, not when you receive the payment. Similarly, if you buy supplies or pay salaries on credit, you record the expense when you incur it, not when you pay it.
Pros of the Accrual Method
- Accrual accounting gives you a more accurate picture of your business performance and profitability over time, as it matches revenues when earned and expenses when incurred.
- Accrual allows you to track your accounts receivable and payable, which are important indicators of your cash flow and liquidity.
Cons of the Accrual Method
- Accrual accounting is more complex and time-consuming than cash accounting, as it requires adjusting entries for accruals and deferrals at the end of each accounting period.
- It does not reflect your actual cash position, which can be misleading if you have a lot of unpaid invoices or bills.
- Accrual accounting may not be suitable for some types of businesses that deal mostly with cash transactions, such as restaurants or retail stores.
What is Cash Accounting?
Cash accounting is a method of recording revenues and expenses when cash is exchanged. For example, if you sell a product or service for cash, you record the revenue when you receive the cash. Similarly, if you buy supplies or pay salaries with cash, you record the expense when you pay the cash.
Pros of Cash Accounting
- Cash accounting is simpler and easier than accrual accounting, as it does not require adjusting entries or tracking accounts receivable and payable.
- It shows your actual cash position at any given time, which can help you manage your cash flow and budgeting.
Cons of Cash Accounting
- Cash accounting does not give you a clear picture of your business performance and profitability over time, as it does not match revenues and expenses to the periods in which they are earned or incurred.
- Cash accounting does not allow you to measure your inventory turnover or cost of goods sold, which are important metrics for some businesses.
- Cash accounting may not comply with generally accepted accounting principles (GAAP) or tax rules for some businesses that have more than $25 million in annual gross receipts.
How to Choose Between Accrual and Cash Accounting
There is no one right answer to which accounting method is better for your small business. It depends on a range of factors such as:
- Your business type: Some businesses are more suited for accrual accounting than others. For instance, if you sell products or services on credit or have long-term contracts with customers or suppliers, accrual accounting can help you track your revenues and expenses more accurately.
On the other hand, if you deal mostly with cash transactions or have short-term operations, cash accounting can be simpler and more convenient.
- Your business size: Generally speaking, larger businesses tend to use accrual accounting more than smaller ones. This is because accrual accounting can provide more detailed and reliable financial statements that are useful for external users such as investors, lenders, or regulators.
Smaller businesses may prefer cash accounting for its simplicity and ease of use.
- Your business goals: Your accounting method can also affect your business goals and strategies. For example, if you want to grow your business or attract funding from outside sources, accrual accounting can help you show your potential profitability and growth prospects.
If you want to minimize your taxes or save on accounting costs, cash accounting can help you defer income or accelerate expenses.
- Your personal preference: The choice between accrual and cash accounting is up to you as the business owner. You should choose the method that best suits your needs and preferences.
- Consult with a professional accountant or tax advisor before making a final decision.
Accrual and cash accounting are two different methods of recording revenues and expenses for your small business. Both methods have advantages and disadvantages that depend on factors such as your business type, size, goals, and preference. You should weigh the pros and cons of each method carefully and choose the one that works best for you.
If you have accounting questions or need help determining which accounting method is right for your small business, please contact us.