If you are a small business owner, then you know the importance of keeping an accurate account for all accounts. Fortunately, you can adopt two accounting methods to manage your bookkeeping accurately:
It is important to learn how each one performs in a business so that you can decide the correct accounting method for your company.
There is a huge difference between the Cash Basis or Accrual Basis Accounting when it comes to record accounting transactions. It is the timing of the transactions that differentiate both. We will explore cash and Accrual methods in detail and how both can affect your company. Also, in this post, you will learn what is better for you, Cash Basis or Accrual Basis Accounting.
Cash Vs Accrual Basis Accounting: A Brief Description
One of the major questions of new startups and small companies is how to decide which accounting method is better for their businesses. Cash or Accrual basis? Well, let’s explore both in detail below.
This method depends entirely on the company’s cash activity. It records revenue when cash comes in and goes out. Cash basis is the easiest form of accounting and normally doesn’t require any Generally Accepted Accounting Principles guidelines. Here, you can record revenue the moment you get cash from clients. Also, the expenses get recorded at the time you pay cash to suppliers’ employees. Numerous small businesses use this method to monitor their cash flow daily.
The cash basis accounting method accepts all received revenue as well as expenses when the money is paid. It simply means that when you look at your account balance, you know exactly how much resources you spent and how much is remaining.
Since the revenue isn’t recorded until it is received or paid, the income isn’t subjected to state tax until it’s kept in the bank. Plus, cash basis accounting is simple to maintain. But, the drawback is that this method doesn’t always show a correct image of your company’s financial state.
For example, if your business has tons of cash but at the same time has numerous unpaid account payables then your bank account will look good but the reality is something different.
But it could deceive investors to think that your company is making a profit. On the contrary, the truth is that it is losing cash due to unpaid accounts payable.
So, cash basis accounting might not give you a proper insight into how your company is performing.
Accrual Basis Accounting
Accrual basis accounting documents revenue when it’s earned or expenses are billed. This method records revenue the moment an item or service reaches a client (it doesn’t matter if money is received or paid). For example, the revenue/transactions are recorded after the completion of a project not when you receive payment.
It is widely used by large businesses but is tougher and labor-intensive. This method provides a better insight into your company over the long term. Also, it is beneficial for those businesses that own huge quantities of inventory.
But, the accrual method can’t actively track the company’s cash flow. This thing can impact your businesses during a cash shortage as the company will spend more than it has because it seems to be profit-making in the long term – as they have lots of revenue reports but all unpaid, so the company has no cash left in the bank.
So, here while using this method, it is mandatory to hire someone to monitor the revenue and expenses to keep track of the actual cash position.
Choosing the Best Between Cash Vs Accrual Basis Accounting
Cash basis is suitable for new startups because here the accounting is simple and the company can concentrate on future planning.
Before choosing any of the accounting methods for your startup, you need to ask some basic questions.
Will you ever sell your company in the future?
Will the business go public anytime ahead?
Does your company require bank financing?
- Will they audit the company books?
If you chose Yes to any of the questions above then you should go for accrual basis accounting. The reason is that external parties and investors want complex reporting to see how well the company is performing.
Accrual basis accounting is a preferred option as it allows for Generally Accepted Accounting Principles guidelines.
Also, if the company’s sales are exceeding 5 million on average during three years, then you must opt for accrual basis accounting.
Examples to Help You Choose Among Cash Vs Accrual Basis Accounting
Your decision depends upon the business you have. To help you understand better, read out a few examples given here below.
Suppose, a client is using cash basis accounting. Now, there is a sudden growth in the business. Here, cash basis is unable to give a proper insight into the company’s performance and cash flow becomes an issue.
Now, the client converted to accrual-based accounting and started using key performance indicators to see the trend of financial standing. When the cash was less, the client created sales outstanding (DSO) KPI of the day to cope up with the cash projections. This is because even after the growth, only a little money was in the bank. It helped the client to see the problems clearly and the amount of cash left in the bank at that point.
Now, there is one more client who continues flowing cash basis as they have fewer activities to perform. The company doesn’t want to follow tough accounting as they are making less money. Being a small company, cash basis accounting suits them perfectly.
Reporting with Accrual and Cash Basis Accounting
It is super important to check what is happening with your company. Accrual offers you a clearer view in terms of profitability. You can monitor trend analysis as you have to recognize revenue and expenditures when the company earned revenue and paid expenses.
Not only this, you can easily track the monthly burn rate to work on expenses and estimate your gross profit to cover all expenses.
Cash basis accounting is behind accrual basis because it shows major fluctuations. This is because a company can have a profitable first month and average next month due to receipts timing and cash going out. So, it doesn’t show the true profits of a project. Therefore, to see the actual progress, choosing an accrual basis will be best.
To Wrap Up
By now, we believe that you got a decent idea about both cash basis or accrual basis Accounting, and what is better for your business. This article includes all the benefits and advantages of both accounting methods along with examples.
We hope that you found this informative post relevant. However, if you have any queries in your mind then do write them below in the comments section. We will surely respond to you.