As a small business owner, you must understand the accounting aspect of your business. How is money being received and paid out of your company? Even if you are not directly responsible for finances, it is crucial to understand how the finances of the business are operated. For most small businesses, there are two main ways that finances are recorded and handled: cash basis accounting and the accrual accounting method.
The cash basis accounting method is the simpler of the two methods. Thus, most sole proprietorship and partnerships opt for this method. For this type of accounting, expenses are recorded only as the money leaves the company and income is only recorded as it is received. For example, if you’d invoiced a client $1,000 in December but received the actual cash in January, then you would record the income as income for January.
The primary advantage of the cash basis accounting method is that it is simple and easy to use. When the money is received or transferred from the company’s account, you record it as it moves. This makes it simple to understand. Also, for income tax, you don’t have to pay taxes on any money that has not yet been received.
Cash basis accounting does, however, obscure the financial situation of the business. As the payments are often not from the same month, it is hard to see how the company is performing during a particular month. While you may think you are having a good month, it could simply be payments being received for earlier work.
The accrual accounting method differs from the cash basis accounting method in that transfer of money is recorded as soon as the check has been issued or the invoice sent. Even if you hadn’t actually received payment yet, it is recorded in the financial books. To keep the earlier example, if you’d invoiced a client $1,000 in December, you’d still record the income as income for December even if the actual payment is received in January.
The major advantage of the accrual accounting method is that it gives the owner a clearer look at how the company is doing financially on a long term scale. Indeed, the information is more accurate as well and can be better used for projections.
Accrual Accounting method is, however, more complex than the cash basis method. It also reflects an inaccurate account of the company’s short term financial situation. Extra resources are needed to keep track of bookkeeping, especially as customers don’t pay and then write-offs need to occur if those receivables are eventually written off.
While the decision for which method your business uses is up to you, it is also important to consider your goals and the resources that you have available. If your company makes less than $25 million in gross annual sales, then you are free to choose either method, whereas if your entity makes more than that, the accrual method is required. For help understanding which method is right for your business, contact Foster Financial CPA for assistance.