Many new business owners don’t give much thought to the accounting method they’ll use. If you have a CPA, maybe they mentioned how tax returns get filed on a cash basis – but what if you’re not sure what that means? Have you noticed something irregular in your statements, and you can’t pinpoint the issue? Whatever the case, the reason your financial paperwork appears as it does is due to your use of one of the two acknowledged methods of accounting for small business.
As your company’s management, it’s important you know what the two accounting methods are, who can use which method, and when one method is better than the other. At the very least, it’ll help clear the confusion when reading your financial statements and why certain items get documented while others don’t.
The biggest advantage is you’ll better understand your company’s bottom line. This helps you make sound financial decisions pertaining to your business which can greatly help your bottom line in the long run.
So, what are the two main styles of accounting for small businesses?
Cash-based accounting identifies revenue whenever the company receives cash and identifies expenses only when they’re paid. The cash-based method of accounting does not factor in accounts receivable or payable.
A lot of small businesses choose cash-based accounting for its simplicity. Recognizing when transactions have occurred is easy – when you receive money, it’s in your bank account; when you pay a vendor, the bank debits the funds from your account. Thus, there’s no reason to track accounts payable or receivable.
There are benefits of using cash-based accounting. For instance, this method is perfect for knowing the exact amount of cash your business has at any point in time. And, since you record no transactions until you’ve actually received or paid out cash, any income received isn’t taxable until it is in your account.
This accounting method records revenue and expenses when you earn or pay them, independent of when you actually receive or pay out money. For example, you record revenue at the completion of a project instead of when you’re actually paid. Of the two accounting methods, this is the most commonly used.
A benefit of using the accrual-based method of accounting is you have a realistic picture of your revenue and expenses over a given period. This provides insight into the long-term potential of a company – cash-based accounting cannot.
On the other hand, using accrual-based accounting doesn’t give you an idea of your current cash flow. You might think business is booming – but in reality, your bank account is empty. Accrual-based accounting can be potentially devastating if you don’t keep a watchful eye on your cash flow.
Results of Cash-Based and Accrual-Based Accounting
It’s important to understand the various differences between cash-based and accrual-based accounting, but this is really only possible if you examine the direct result of both methods.
In the following examples, notice how each method can affect your company’s bottom line.
Suppose your company is in the web design business. In the span of a month, you had the following business transactions:
Sent an invoice for a website your team created this month – $4000
Received an invoice for this month’s developer fees – ($1000)
Paid late fees for a bill that was due last month – ($75)
Received a payment on a project you invoiced for last month – $1000
How does your financial picture differ between the two accounting methods?
Cash flow effects
If you use the cash-based method, you’d show a profit of $925 (the payment you received minus the late fees you paid). Using the accrual-based method, your month’s profit would instead reflect $3000 ($4000 from the website minus developer fees). Your cash flow looks very different depending on the accounting method in place.
Suppose the example above occurred between the months of November and December of last year. Another main difference between cash-based and accrual-based accounting is the effect they have on your reporting year.
In cash-based accounting, you record your income as it’s given to you, as opposed to accrual-based where it’s recorded at the time of earning. In the given example, using accrual-based accounting, any invoices you created in December are income for that year. You would owe taxes on that income with that year’s return even if don’t receive the actual invoice payment until January of the following year.
What Types of Businesses Should Use the Cash-Based Accounting Method?
Cash-based accounting is perfect for sole proprietors or companies that have no inventory. If your business provides small services, such as housecleaning, or if your business is itself cash-based, such as a laundromat, cash-based accounting might be appropriate. If the business is new, it can be an advantage to start out using the cash-based method – you can hold off counting any income until the following tax year, yet count your expenses immediately. It’s still a good idea, regardless of the type of business you’re in, to check with a knowledgeable CPA regarding your exact circumstances.
What Types of Businesses Should Use Accrual-Based Accounting?
If your company stocks inventory, you’ll most likely have to use accrual-based accounting. In fact, this is the perfect type of business for illustration purposes. Say you’ve purchased inventory for your business – you incur that expense, and you may also then sell some of that inventory that month that you’ll be able to match to your inventory purchase expense. But what if you sell some of the inventory on credit? You might not receive payment for those sales in the same period that you report the expense, which is just one of the reasons small business accounting is so complex. This is precisely the reason for the adoption of accrual-based accounting.<
So many businesses today operate globally, adding to the already intricate nature of business – but accrual-based accounting allows an exact, current snapshot of a business at any time. Cash-based accounting just wouldn’t stand up to the test of a global market.
How to Choose the Right Accounting Method for Your Small Business
United States tax codes state that certain businesses can choose the accounting method best for their type of company – but you can’t use both cash- and accrual-based. Whichever method you use for your statements and reports must be the same when filing taxes. For example, you can’t spend the year using the accrual-based method, and then file your taxes based on a cash-based method, or vice versa.
Also, you must apply the “matching principle” standard. This principle states that you must recognize your expenses at the same time you recognize the income that created the expenses, hence – matching the two.
Accounting standards in the US require businesses choose accrual-based methods for their financial reports. If yours is a small business, isn’t traded publicly, and you’re not required to disclose your financials, you could qualify to operate under the cash-based method.
By the time you’re ready to file your business’ first tax documents, you’ll need to have chosen the accounting method you’re going to use. Then, you’ll have to stick to that method for every subsequent return you file. Speak with accounting professionals to help determine the accounting method that fits your business best.