When you own a small business, one of the first things you need to decide is how you're going to keep your books. Accounting is a process used to record important financial information about your business dealings. Accrual accounting and cash basis accounting are two different methods used to keep track of business finances. Understanding the basics of these two methods is key to picking the right one for your business. Check out our guide below to learn more about accrual and cash basis accounting.
Understanding the Difference Between Accrual Accounting and Cash Basis Accounting
The Financial Accounting Foundation (FAF) has two boards that work together to set accounting standards in the United States. The Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB) establish Generally Accepted Accounting Principles (GAAP). You must adhere to these principles unless you qualify for a small business taxpayer exception, according to the Internal Revenue Service (IRS).
Accrual accounting meets GAAP standards - cash basis doesn't. Businesses can use both accounting methods at the same time to track all expenses and income; however, larger businesses must use accrual accounting.
Another difference is that cash basis accounting is a short-term view of a business's cash flow. It shows how much money is currently in the bank. Accrual accounting is a long-term view of a business's finances. It shows earning and spending trends over a longer period. Let's take a closer look at each method.
What Is Accrual Accounting?
Accrual accounting is a process that records revenue and expenses when they're earned but not actually received. It deals solely with a business's expected income and expenses. For example, if you use Skynova's free invoice template for invoicing a client in April, the income from that bill is recorded on the invoicing date instead of when the client pays it.
Accrual accounting is useful most often for larger businesses that need to see financial gains and losses over a period, such as a year. It's a more complicated type of financial recording that shows a business's overall finances, not just a cash balance. However, most companies want to see their actual cash flow, so that's why cash basis accounting is another method worth using.
What Is Cash Basis Accounting?
Cash basis accounting is a method in which you record income when it's received and record expenses when they've been paid. It deals with actual numbers and dates, much like balancing a checkbook - money comes in, and money goes out. Like sole proprietors and partnerships, many small business owners prefer to use it since it's the simpler of the two methods. It's a good choice for those who don't sell merchandise directly to customers.
No accounts payable or accounts receivable are taken into account with this method. Cash, check, or credit card payments from customers are recorded on the day they're received. Any payments made by your business to a third party are recorded on the day they're processed. For example, a supplier sends you an invoice in April that's due in May. The expense would be recorded when you pay it in May.
What Is Bookkeeping?
Bookkeeping is the process of recording and organizing a company's financial transactions. It's part of accounting and varies according to the type of accounting method you use. Bookkeepers are people who record transactions. They may also be responsible for sending invoices, making payments, managing accounts, and preparing financial statements, such as a balance sheet or a cash flow statement.
If you need help with keeping accurate financial records, consider using Skynova's accounting software. Expertly designed with small businesses in mind, it's as intuitive as possible and provides features such as a general ledger, an invoice template, and a journal for important notes about transactions.
Our accounting software also allows you to choose between accrual and cash accounting, track expenses and sales tax, and store receipts. Run financial reports and ensure bookkeeping accuracy with our double-entry accounting feature. Should you need any further help, Skynova's support team is available seven days a week.
The Advantages and Disadvantages of Accrual and Cash Basis Accounting
There are pros and cons associated with different methods of keeping financial records. Let's explore some advantages and disadvantages of accrual accounting and cash accounting. Use these details to broaden your understanding so that you can make the right decision for your business.
Advantages and Disadvantages of Accrual Basis Accounting
In some cases, you have the choice to use accrual accounting, so take the following information into account when weighing your options. Some advantages of accrual accounting include:
- A more accurate picture over time: The accrual method matches income and expenses to the correct year. It allows you to see a clearer picture of your business's finances and profitability over a longer time period. This advantage helps you notice trends like consumer spending. When you have this view, you can make more accurate decisions based on your company's financial trends.
- Meets GAAP standards: If you don't qualify for a small business exception, you must use the accrual method of accounting, which meets GAAP standards. These principles are designed so that your financial information can be properly organized into accounting records and financial statements.
The disadvantages of the accrual accounting method include:
- Less accurate short-term financial picture: Since this method doesn't record when money has been paid or received, it doesn't show a current balance of your business. Not knowing how much cash you have is a problem that can lead to overspending.
- Paying taxes on money owed: This problem comes up when you claim income that hasn't been paid. For example, you complete a job and invoice the client in December, so you record that income for December. However, you don't receive the money until January. So, you would be paying taxes on money that hasn't made it into your business bank account.
- More complicated method: Small businesses with only one or two owners may find it harder to understand and use the accrual method. It's a more complicated way of keeping track of your finances and can be tricky to master, especially if you don't have any accounting experience or an accounting department.
Advantages and Disadvantages of Cash Basis Accounting
Cash basis accounting can be used by small and large businesses alike, either as the only accounting method or in conjunction with accrual accounting. Here are some advantages of cash basis accounting:
- Simpler method: In this cash method of accounting, you only need to worry about when money changes hands. It's simple addition and subtraction that doesn't take much time to accomplish.
- Clearer short-term view: The cash basis method allows you to track cash flow accurately. It's important to know how much you have when making spending decisions.
- More accurate for income tax: Since you only record revenue once it's received, you won't have to pay taxes on any revenue you haven't received.
Some disadvantages of cash basis accounting include:
- Doesn't meet GAAP standards: This means you can't use only the cash method to keep financial records when you're classified as a large business by the IRS. Businesses with more than $25 million in average annual gross receipts from the prior three tax years can't use only cash basis accounting.
- No long-term financial picture: Since this method shows the daily ins and outs of your business's finances, you don't see a long-term picture of where things stand. Cash flow one month could look better or worse not because of current business but because of transactions from a previous month.
How to Pick the Right Accounting Method for Your Business
When it comes to bookkeeping, some businesses choose to use an accrual accounting system, while others pick cash basis accounting. Often, businesses use both methods for their advantages. No matter which method you choose to use, it's very important to keep accurate financial records for tax purposes. Also, you can't switch accounting methods mid-tax year, according to the IRS.
Very small businesses and those that don't need to stock inventory are likely better off using the cash basis accounting method. Larger businesses that produce, purchase, or sell merchandise directly to customers must use the accrual method. They may also want to use cash basis accounting to see a clearer picture of their cash flow.
It's a smart move to talk with your business partner and consult an accounting specialist, such as a certified public accountant (CPA), to decide which accounting method is right for your business. Skynova's business software products are also available to help meet all your small business needs. From invoices to receipts, our business templates are specifically designed to make creating and tracking finances so much easier.
Skynova's all-in-one invoicing and accounting software helps you keep accurate records of your business's income, expenses, sales tax, and payments. All financial information for filing taxes will be stored in one safe location. Check out Skynova's business products to fulfill all your small business accounting needs today.