Understanding Cash Basis vs. Accrual Accounting

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As the owner of a growing business venture, you are likely aware of the importance of bookkeeping. There are a few ways to keep track of your company’s financial transactions. You can use either cash basis accounting or accrual accounting.

Each method has its merits. If you are not sure which option is best, you should consult a financial accountant. They are professionals with experience working with many enterprises, and they will know which method is best for accounting for startups and small businesses.

Cash Basis Accounting

In this method, you only record expenses and cash inflows when they happen. If you have invoiced a customer for items delivered, it will not be registered as a sale until your customer makes an actual payment. Similarly, you will not record an expenditure until you have remitted the amount in question.

This accounting method is much less involved than accrual accounting, and thus, much more tempting to small business owners. Since it doesn’t require tracking account receivables and payables, you can do your own bookkeeping and not need to hire a dedicated resource for your accounting.

Cash basis accounting is also ideal because it gives a more accurate picture of the cash your business has on hand at any given time. However, this method will not provide an accurate snapshot of your business’s financial status, as it doesn’t show what you are owed or what you owe. This makes cash basis accounting less ideal for larger enterprises and corporates. IRS regulations will require you to use accrual accounting if you earn more than $25 million in sales yearly.

Accrual Accounting

Here you record a sale as revenue as soon as you invoice your client instead of waiting until you receive payment. You handle expenditures the same way; whenever you’re billed or issued an invoice for services rendered, you record this as a cash outflow. Income that is yet to be received will be recorded as accounts receivable and expenses that are yet to be settled as accounts payable.

This method of accounting gives a more accurate picture of the financial health of a company. It will also help you keep track of pending payments and clients who delay payments. Since it shows the overall picture of your finances and not just the cash, you have presently, accrual accounting is better to present to potential investors.

What Difference Does It Make?

Cash basis accounting only keeps a record of what is reflected in your bank account at any given time. This model does not factor in expected income, expenses, or unsettled bills. While more straightforward, it will not give your finances the complete status at that particular time.

If you want a more accurate general picture of your business in the present and the near future, you’re better off using accrual accounting. It is more time consuming and requires a higher level of expertise to maintain, but it will provide you with essential details that the cash basis model cannot give.

Accrual accounting will show accounts receivable and accounts payable, which is essential for larger businesses, as they often operate on a credit basis with suppliers.

If your business is a startup with few expenses and relatively few clients who pay in cash, cash basis accounting will be ideal for you. Since you are dealing mostly in cash, this accounting model will still offer a relatively accurate picture of your company’s financial status because the cash transactions recorded daily will be a full reflection of all of the company’s economic activity.

Another benefit cash-basis accounting offers small business owners is that you only pay tax on income received. Since you record inflows as soon as you invoice your clients in accrual accounting, you will need to declare this as part of your taxable income. Doing this exposes you to the risk of paying tax on income you may never actually receive.

From a long-term business perspective, accrual accounting is a better option. It will offer you more details relating to your cashflows, some of which enable you to make reasonably accurate projections of your revenue. Knowing which months might have a slim profit margin and which customers tend to delay payments can help you make better decisions to improve your business. You will be better equipped with the information investors need to decide if they should take a chance on your business.

Choosing Which Is Best for You

Given each of these accounting models’ pros and cons, it can be challenging to know which is best for you as the owner of a growing startup. Cash basis accounting may seem like the easy choice, but it may be cumbersome to start changing systems as your business grows, and you wish to realize the benefits of accrual accounting.

A professional accountant can help you make this decision based on their experience with similar businesses. A CPA will know which accounting system is best suited for your startup or small business and help you implement it.

 

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