There are two main methods of accounting, Cash and Accrual. To select which method best complements your business, let’s first understand how they work. The main difference between the two methods is the time frame in which revenue and expenses are recorded in your books.
With cash accounting, income is recorded when it is received, and expenses are recorded when they are paid. For instance, when you invoice a client, you would not record that income until the client pays the invoice.
Advantages of the cash accounting method: It is the most straight forward and easiest method to manage for small businesses. It’s easier to manage cash flow and in addition, it can have some deferred tax benefits. For example, let’s say you were working on a project you were hired for in December, you had to buy supplies to complete the job and the supplies cost you $5,000. However, you won’t be done with the job until January, so on December 31st when you close your books, you will be showing a loss on that particular project because you have not received the income yet. Applying this method as a tax strategy can help minimize tax liability.
A disadvantage of the cash method is that it does not paint an accurate picture of the financial health of the business since cash accounting is limited to only recording cash transactions as they are received. This does not take into consideration accounts receivables that may be due to the company.
Types of companies that are best suited for the cash method are small businesses that may be sole proprietors or partnerships or if you only need to record a few financial transactions. Also, if you pay cash for company operations and don’t require investor funding to run your business.
With accrual accounting, income and expenses are recorded when they are billed and earned even if the money has not been received yet. For instance, if you have completed a project at a cost of $15,000 when you invoice the client, you record the revenue in your books on the day of invoice, even though you have not actually received the revenue yet.
Advantages of accrual accounting: It shows a more accurate picture of the financial health of the company. In addition, because accrual accounting allows you to account for all your revenue and expenses during the appropriate period, plus it’s great for operational planning purposes.
Disadvantages of accrual accounting is not having an accurate picture of your cash flow because you have recorded revenue at the time of invoicing, but the revenue has not actually been received yet. In addition, record keeping for accrual accounting is more complex than cash accounting and requires the practice of double entry accounting. In most cases, you will have to hire an experienced bookkeeper or accountant to manage your books for you.
Types of companies that are best suited for accrual method accounting are larger companies. That includes companies that have inventory, companies that are structured as a C corporation, and companies that require capital funding.
Both methods have advantages and disadvantages and it is always a good idea to speak with an accounting professional to assist you with the best strategy for your company.
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