Hey, hey, hey to all you fabulous entrepreneurs out there!! I hope you are conquering the world with your swords of excellence. It’s your favorite Money Motivator – Growth Instigator, Erica Fields bringing you the keys to your financial house!! I hope you are enjoying this day and are receiving all the fruits of your labor.
Today’s topic is about accounting methods: cash versus accrual and which is right for you. When selecting your bookkeeping service solution, you may get the question as to whether your company will be using the cash or accrual method and most of us are left with confusion as to which we should choose.
Every business needs a bookkeeping system, like QuickBooks Online, to track and reflect their income and expenses. There are two common methods of tracking these details: the accrual method and the cash method. The difference between these methods is the specific timing of when sales or purchases are “recognized” or added to the ledger book. Most of small businesses have the option to choose their method of choice. But, which method is right for your business?
The Cash Method
With the cash method, a business would not count their income until payment is received from the customer. Expenses are also not counted until the money has been spent. None of your bills are accounted for until after you have already paid for them. For example, the cash method does not allow for a store to bill customers for products at a later date, as there is no system in place to track money due from customers.
This method is the most popular among small business owners because it is the easier to use and is useful for tracking historical cash flow. Without considering the flow of cash through your business, you can end up without enough cash on hand to cover operating expenses, such as rent and payroll. However, it can be difficult to match specific expenses to the revenue they helped generate using this method.
The Accrual Method
The accrual method records all transactions into the books as soon as they occur, whether or not any cash is collected or spent. If offer store credits to your customers, it would be recorded when issued in the Chart of Accounts under “Accounts Receivable”.
In the same, any credit purchases you make would be recorded into an "Accounts Payable" account when incurred. This method provides a more accurate view of the income and expense, or debt, your business incurs. But, it does a poor job of tracking actual cash on hand and can be a deterrent to the cash flow process. If your customers aren’t quick to make their payments, or you are faced with a situation where they don’t pay at all, you could end up with little or no cash to cover expenses, even though you’ve earned the revenue.
Choosing a Method
As mentioned above, most small businesses choose the cash method of accounting as they are establishing their bookkeeping systems, especially in the case of small businesses who are service providers with no inventory. But, as their businesses start to grow, they often switch to accrual accounting so that they can track revenue and expenses more accurately.
In the U.S., a business is required to use the accrual method if they have sales of over $5 million per year, or over $1 million if they have inventory. When the accrual method is applied, many businesses will still resort to monitoring cash flow to make sure the business has enough cash on hand to operate at all times.
Depending on your business needs, either of these accounting methods will give you a picture of your financial house. However, to best position your business financials and to gather the most information for your books, you should employ elements from both methods. Some business owners keep a cash account separate from their accrual account which allows them to monitor their cash flow in addition to the long-term financial needs of their business.