LET’S GET STARTED
- 1 Single or Double Entry Bookkeeping
- 2 Cash Basis Accounting
- 3 Accrual Basis Accounting
- 4 Hybrid Methods of Accounting
- 5 What Does it Mean to “Record Transactions”?
- 6 The Effect on Cash Flow
- 7 The Effect on Taxes
- 8 How to Choose the Right Option for your Business
- 9 Conclusion
Unlike Baskin-Robbins, accounting only comes in three flavors - cash basis accounting, accrual basis accounting, and hybrid accounting.
As a small business owner, one of your first major decisions is to decide between cash and accrual accounting. You may prefer to hire bookkeeping services or accounting services and leave the decision to a professional. However, it is still advantageous to know the essential procedures of small business accounting.
Typically, companies with annual sales below $25 million can choose to use cash basis accounting, but beyond that, the IRS requires you to use accrual accounting. That being said, getting started with accrual accounting sooner will save you lots of headaches down the road.
So what is the right option for your company?
Single or Double Entry Bookkeeping
The main difference between cash accounting and accrual accounting is at what point a company records revenue or expenses.
Cash basis is a single-entry method of bookkeeping in which revenue and expenses are recorded only when cash is received or leaves your bank account. The cash method is popular with sole proprietors and businesses without inventories.
With accrual accounting, revenues and expenses are noted in advance. This is how it works: When the company receives a bill, it is recorded in the ledger book before it is paid, and revenue is documented when a product or service is provided to the customer with the expectation that the invoice will be remunerated within a short time. In short, expenses of goods and services are placed on the books when the bills are received, but not paid, and invoices are placed on the books before customers pay them.
Cash vs. Accrual Accounting at a Glance
|Cash Accounting||Accrual Accounting|
|Cash is recorded at the time revenue is received||Revenue is logged when it’s earned|
|Expenses are recorded when cash is spent||Expenses are recorded when they are billed, or when the company receives an invoice|
|The company does not pay taxes on revenue that has not been received||The company owes taxes on money that has been invoiced to a customer but not yet paid|
|Popular with small businesses and sole proprietors with little or no inventory||Mandatory for businesses with annual revenues greater than $25 million|
Cash Basis Accounting
Cash basis accounting’s advantages include its simplicity and it also lets the owner ascertain how much money the business has in its accounts at all times. For small companies conducting business mainly through cash transactions and without large inventories, the cash accounting method can be a useful and dependable way to track revenue and expenses without the need for complex bookkeeping services.
With cash accounting, the business only pays tax on revenue that has been received which can boost cash flow. Many small businesses opt to use the cash basis of accounting because it is simple to maintain and it is similar to tracking personal finances.
It is easy to determine when a transaction has occurred - the money either has been deposited in the bank or has been deducted from the account. In addition, it is not necessary to track accounts receivable or accounts payable.
Accrual Basis Accounting
With accrual accounting, you log income in the ledger book as soon as you present an invoice to a customer, even if it is not paid right away. Likewise, when a company receives a bill, it is acknowledged as an expense even if you don’t pay it for a month or more. Accrual accounting is much more common than the cash method.
Accrual accounting’s advantage is that it provides a more precise sense of income and expenses over a fixed time period even if no money is exchanged, and provides the company a much more accurate, long-term picture of the business and financial records than cash accounting.
Accrual accounting’s disadvantage is that it does not provide an accurate picture of cash flow. In fact, a business can seem like it is generating profits even though it has no money in the bank. That is why accrual basis accounting requires careful observation of cash flow to avoid serious problems.
Even if you do not handle your own financial reporting, it’s vital to know how each one works so you can choose the best bookkeeping practices for your business.
Hybrid Methods of Accounting
Companies also choose to combine accrual accounting and cash accounting for their business, or what is called hybrid accounting. For example, a firm may rely on accrual accounting to manage large financial decisions and loan applications but rely on cash basis accounting to monitor cash flow or handle aspects of their tax liabilities and payments.
Businesses often prefer accrual accounting to monitor inventory and obtain a more robust sign of business performance because it indicates when income and expenses happened. Accrual also informs the business owner of important financial milestones such as if the company generated a profit in a specific month.
Some businesses also utilize cash basis accounting for some income tax reasons, but few companies only rely on cash accounting. The accrual method is considered the most accurate way of maintaining financial records.
The hybrid method of accounting may be complex for a company owner who lacks accounting or tax experience so it may be necessary to contract bookkeeping services.
What Does it Mean to “Record Transactions”?
Whatever method you use, accurate financial record-keeping is crucial in both methods. Purchases, sales, receipts, and payments, as well as accruals for payables or receivables, must all be logged with care in your ledger by a bookkeeper.
A company must accurately record these transactions as part of its accounting:
- Sales and revenue transactions, including cash transactions
- Accounts receivable if credit has been extended to your clients
- Accounts payable, if you have used credit to purchase items from your suppliers on credit
- Summaries of transactions in your general ledger
Once data is centralized in one place, the company can obtain financial data insight in a quick and cost-effective way. For example, recording all income and expense transactions is also vital in order to claim year-end tax deductions and compile financial statements. Unlike cash accounting, which provides a clear short-term vision of a company’s financial situation, accrual accounting provides the business owner with business insight and a long-term view of how the company is performing.
The Effect on Cash Flow
As an example of bookkeeping with cash accounting, let’s say if you sent an invoice to a client for $3,000, due next month, and the client paid a $500 deposit to you this month. With cash-basis accounting, the company’s income for the month would only be $500 because the remaining $2,500 is still outstanding.
However, with accrual accounting in this scenario, you are recognizing the full $3,000 as income (both the liquid $500 and the unpaid $2,500) in that accounting period. Likewise, you will be recording what you owe ahead of time as a debit. This process enables you to make smarter financial projections and increases the size of your cash flow.
The Effect on Taxes
Another major distinction of accrual versus cash accounting is in bookkeeping for tax purposes. When it comes to taxes, cash basis accounting has advantages because you are required to pay taxes on any income that has not yet been paid by a customer. For instance, if you sent an invoice to a client or customer for $2,000 in October and are not reimbursed until January, you would not be required to pay taxes on the income until January of the following year.
With accrual accounting, revenue is recognized and recorded at the time of a transaction, i.e., when a product is shipped or a company performs a service. As a result, businesses must pay taxes on revenue booked for the current tax year. This means you could be liable to pay taxes on an invoice in this tax year, even though the customer ultimately paid it in the following tax year.
For example, your company bills a client $500 for services that you performed in December 2020 and you receive full payment in January 2021. You would have to include the $500 in 2020 gross income, the year the income was recorded in your books.
How to Choose the Right Option for your Business
Small business owners must maintain accurate books and properly record expenses and revenues to maintain a profitable business. Many owners and entrepreneurs want to focus their time on energy on growing their company and improving their products and services, but may not be enthusiastic about structuring their accounting process.
Once a business owner chooses between accrual and cash accounting, and files taxes according to this method, you will need to seek approval from the IRS to change the accounting method that was chosen by your company.
The cash method typically is superior for small businesses without inventories. If your company has a large inventory, your accountant or bookkeeper will probably counsel using the accrual method.
As far as taxes, cash basis accounting has definite advantages. With this method, you are not required to pay taxes on any invoices that have not yet been paid. For example, if you send an invoice to a client or customer for $2,000 in October, but are not reimbursed until January, you won’t pay taxes on the income until January of the following year. This boosts cash flow and helps your small business set aside funds to pay taxes. For individuals and extremely small businesses, this can help your business when cash flow is tight.
The cash method is simpler, but it has disadvantages. Because it does not account for all income sources and outgoing expenses, the cash accounting method can mislead you to believe your company is having an excellent cash flow in a month, but it may be because of the previous month’s transactions and income.
Unlike cash accounting, which provides a clear short-term vision of a company’s financial situation, accrual accounting lets you see a more long-term view of how your company is faring. Accrual accounting is more complex and requires additional paperwork for a company’s financial reporting process and that may require hiring an accounting professional. As a result, many small business owners consider this method to be too complicated and expensive to adopt.
This is because accrual accounting accurately shows how much money you earned and spent within a specified time period, providing a clearer gauge of when business speeds up and slows down over the course of a business quarter or a full year. Additionally, it conforms to nationally accepted accounting standards. This means that if your business were to grow, its accounting method would not need to change.
Regardless of the method you choose for your small business, if you decide to take care of your own small business accounting, you can still outsource several bookkeeping tasks.
Deciding between accrual versus cash accounting methods for your small business depends on many factors including your corporate goals, your comfort with accounting processes, and your company’s financial obligations.
For most small companies, cash-basis accounting may be the best choice because of its simplicity. Nevertheless, because the majority of transactions are now processed with credit, the accrual or hybrid accounting method may be preferred by many companies. If you don’t know which accounting method is best for your small business, you can talk with a CPA or tax professional.
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