Did you know that every business needs to choose a proper accounting method?
Choosing the proper accounting method applies to small or large companies. In businesses, two main methods can be used. They are accrual and cash accounting methods. Both accrual and cash accounting have advantages and disadvantages. Before selecting a method, understanding these two methods is necessary to increase business performance.
Cash Basis Accounting
- Cash-based accounting is generally suitable for small businesses.
- Entries in the books of accounts are made when cash is received or paid and not when the receipt or payment becomes due.
- Record income when you receive it.
- Record an expense when you pay it.
- It may not provide a complete picture of financial health, as it doesn’t account for money owed or pending expenses.
Accrual Basis Accounting
- Accrual basis accounting records all the income, including how much is earned and spent.
- Record income when you earn it.
- Record an expense when you incur it.
- Revenues are recorded when they are earned and not when they are received in cash, and expenses are recorded when they are incurred and not when they are paid.
- More complex and may require additional resources to manage.
Choosing the Best Method
There are certain differences between accrual and cash accounting. It is decided on the basis of the timing of when you record income and expenses. Choosing the right method to manage accounting will be decided on the basis of the company or industry. Small, medium, or large companies or no matter what type of companies need to use some particular accounting method that suits their business processes. Following GAAP is a more mandatory one. Joining courses in accounts also helps one to get more knowledge on using these accounting methods properly.
The Advantages of Cash Accounting
- Simplicity
When compared to accrual accounting, the cash accounting method is a simple one to use in small businesses.
- Fewer costs
Cash accounting requires less record-keeping and fewer resources, which can help reduce costs for small businesses.
- Easier cash flow management
This method provides a clear and simple view of cash flow, making tracking and managing working capital easier.
The Disadvantages of Cash Accounting
- Less accuracy
Cash accounting doesn’t show when money is earned or spent, so it might not reflect a business’s financial situation.
- Not for all businesses
It doesn’t work well for businesses that offer credit, as it only tracks money when it is received or paid.
When to Use Cash Accounting
Cash accounting is one of the best methods for small businesses. It helps to track money easily. You can also clearly see debit and credit and the balance you have, which helps you to understand profit and loss properly.
If one business sells on credit means using this cash accounting won’t be the best way. At that time, you can use some other methods to show your records properly.
Who Uses Cash Basis Accounting?
Small businesses and freelancers always choose cash-based accounting because of its simple usage. However, there is a certain limit that needs to be considered before using a cash accounting method. For example, If one business earns under $25 million a year and doesn’t sell products directly to customers, this method could be a good fit for you.
Example of Cash Basis Accounting
If you send a bill for $1,000 on March 1 and get paid on April 15, you count the income in April because that’s when you receive the money. Here’s how it works:
- You send a bill for $1,000 in March.
- You don’t record anything in March.
- You get paid in April.
- You record the income in April.
The Advantages of Accrual Accounting
- Better financial reporting
Accrual accounting gives a clearer picture of a business’s performance, helping with planning and decision-making. It also helps investors understand a business better.
- Improved financial comparisons
This method makes it easier to compare financial data over time and see trends without the confusion cash accounting can cause.
- Supports business growth
As your business grows, accrual accounting helps you manage more complex financial tasks smoothly.
Disadvantages of Accrual Accounting
- Complicated
Accrual accounting is harder to use and takes more time than cash accounting. It also needs more detailed records and a good understanding of accounting rules.
- Taxes
At present, paying tax is mandatory from small to large companies. This method makes one pay unnecessary tax to what was not received also. For example, if you send an invoice in December, you may have to pay taxes on it even if the customer pays you in January.
When to Use Accrual Accounting?
The accrual accounting method is more suitable for medium and large businesses. Through this method, you can show proper financial records with full accuracy. It records income when earned and expenses when they happen, not when money is received or paid. This helps businesses see their real profits and make better decisions.
Who Uses Accrual Accounting?
Small businesses can use accrual accounting, but they don’t have to. However, businesses must use it if they:
- Are listed on the stock market.
- Make more than $25 million in sales over three years (as per GAAP rules).
Example for Accrual Accounting
One of the small businesses bills a client $1,000 on March 1. You would record the $1,000 as income in March, even if the payment is received on April 15.
- The invoice of $1,000 on March
- The recorded date for the income in March
The same rule applies to expenses. If your stationery business buys paper supplies on credit in June but pays the bill in July, you still record the expense in June.
- You buy paper supplies in June
- You record the expense in June
Understanding these methods will help you choose the best accounting approach for your business needs. To find out which method is best, joining short-term courses in accounting will help one to acquire more knowledge in the accounting sector.
