Small business owners can understand their true financial situation by understanding the difference between accrual and cash accounting.
Let’s be honest, though, accounting isn’t exactly the most riveting topic unless you are a business owner.
The accounting method you choose should reflect your business. For many small business owners, cash accounting is the preferred method.
Accrual Accounting: The “Trust the Process” Method
In accrual accounting, you record your revenue when you earn it, not when you receive payment. Expenses are treated the same; they are recorded when you incur them, not when you pay them.
Example: You perform work in January to complete a client’s project. They do not pay you until March. You will record revenue in January, when the work is completed, not when you receive the payment.
The upside?
You will see an honest picture of your work activity and effort each month, regardless of when you receive the payment. You will see the actual revenue earned over time. This method can also be useful if you are seeking bank financing or have a complex inventory situation.
The downside?
The accrual accounting method is more complex. Although you show a profit on your books, your bank account may be dangerously low. This creates an illusion of profitability that can lead to risky spending decisions, even though the cash has not yet reached your account. You might also need to upgrade your bookkeeping systems.
Cash Accounting: The “Show Me the Money” Method
Cash accounting is a simpler process. Your revenue is recorded when the payment is received. You record your expense when you actually pay the bill.
Let’s look at the same example we used above. You complete a job for your client in January, but they do not pay until March. Under the cash accounting method, you record the revenue in March when the payment is received, even though you did the work in January.
The upside?
You get an honest picture of your business’s annual work activity and effort, regardless of payment timing. This information will help you better understand your revenue over time.
The downside?
Accrual accounting is a more complex method. While you might show a profit on your books, your bank account can be dangerously low. You may make a risky decision to spend money you think you have, but haven’t received yet.
Which One Should You Use?
You would consider the accrual account method if:
- Your inventory requires tracking over fiscal years.
- You will be applying for substantial financing. (The lender may require this method.)
- Your business has grown to a complexity that justifies the decision.
Use the cash accounting method if:
- You need to know your true cash position at any time.
- You’re a service-based business.
- You are a solopreneur or small business owner.
Why Cash Accounting Wins for Small Businesses
Most small business owners choose cash accounting over accrual accounting. This method provides you with a clear picture because, if your bank account is low, you are not actually a thriving business. Accrual accounting can hide that truth.
Payment delays are not unusual for small businesses. For example, construction companies may have to wait for inspections and approvals, the timing of which is outside their control. Service providers invoice their clients and wait for payments. These are normal business realities. The accrual method may show you are profitable on paper, but you are unable to make payroll or pay suppliers.
Accrual accounting is more complex and costly, which isn’t necessary in most cases. Cash accounting provides a direct view of your actual cash flow.
Final Thoughts
For most, cash accounting is a straightforward choice. It will help you track the actual health of your business and cash position.
It means you will have to wait for the full picture if you have extended payment cycles. However, your accounting will reflect your actual cash situation. When you can clearly see your true cash position, you can manage your business accordingly.
Your specific situation will help determine the best method for you. It is time to talk to a bookkeeper or accountant if you are not sure what method works best for your business. A small-business professional bookkeeper or accountant understands cash-flow challenges and can guide you to the right decision.
At the end of the day, good accounting isn’t nice-to-have; it is essential to your success.
Contact SAP Virtual Resources to determine if you are using the right accounting method for your business.