Small businesses make up the fabric of our communities. Their skills, goods and services provide us all with both necessities and niceties. Among many local benefits, they support our school teams, bring charm and character to our main streets and help fund our non-profits. However, many business owners neither are bookkeepers nor accountants. Faced with the critical job of tracking their income and expenses many business owners get stumped right out of the gate when choosing which accounting method is best for their business.
Understanding Cash vs. Accrual Accounting Methods
Each accounting method presents a business owner with possible advantages and/or disadvantages. Making an informed decision based upon the pros and cons of each as they relate to an individual’s business is a key factor for future strategic planning and reliable reporting. First, they must determine if they have the flexibility to choose one method over the other. If a business makes less than $25 million annually they can decide between cash or accrual accounting methods for their business.
What you need to know about Cash Basis Accounting
The simpler of the two methods, cash basis accounting is considered the ‘method of choice’ for very small businesses, sole-proprietors and entrepreneurs. Cash accounting literally records cash received or cash paid out. If a customer was invoiced on April 22nd but the business didn’t receive payment until May 10th, the income would show on the Profit and Loss (P&L) report for May. Regardless of the client’s payment method – cash, check, credit card, cash basis accounting only records when ‘the money is in hand.’
This is beneficial for tax purposes as very small businesses or individuals only have to pay income tax for monies received. If for example payment for an October invoice wasn’t received until January, that small business owner need not pay income tax until the following year. This can be “crucial to keeping a business afloat” especially in circumstances where cash is tight.
A downside is cash accounting does not account for money owed (Accounts Payable) or outstanding income (Accounts Receivable). Rather it only shows how much money was received from sales. This is not an accurate financial picture and can be misleading as it “[leads business owners] to believe [they’re] having a very high cash-flow month when in actuality this is a result of a previous month’s work.”
What is Accrual Basis Accounting?
Accrual basis shows how much was invoiced or was billed during a specific period of time. It provides a ‘clearer picture’ of a company’s overall financial wealth and health. Contrary to the cash method, the accrual basis records income and expenses as “they are billed and earned, regardless of when the money is actually received.” This can be advantageous during financial forecasting and when analyzing consumer behavior.
In addition to being the preferred method of accounting by accountants, financial planners and lenders, the accrual method ‘conforms to the Generally Accepted Accounting Principles (GAAP)’ and must be used by companies earing more the $25 million in sales revenue per year. It really allows for long-term business planning and promotes a business’ sustainability.
However, given the accrual method of accounting is more involved and complex, disadvantages which present themselves for small business owners lie within bookkeeping, reporting and accurate filings to the IRS.
Business owners who understand business reporting and why the balance sheet, profit and loss (aka income statement) and cash-flow statements matter to the health of their business, will find the decision to choose between cash versus accrual much easier. Ultimately though choosing the right accounting method or even a hybrid of the two, should be discussed with a CPA and/or an accounting professional and never switched throughout the tax year.
Business Support Services (BSS) Northwest, LLC specializes in providing accounting support services to small and midsize companies in Bellingham and the surrounding Whatcom, Skagit and Island Counties. ProFound Impact veteran Business Coach and Intuit Advanced ProAdvisor, Chris McGee collaborates with business owners to help them to better understand their finances and streamline their operational and financial systems to promote sustainable business growth and profitability.