Achieving your business goals takes attention to detail, the right employees, and a financial planning system to make sure you increase your profits. Tracking your finances is especially important. To do this well, you’ll need a solid accounting method. If you are a new business owner or getting your finances in order, it’s important to find the right accounting method for you.
An accounting method is a set of rules and procedures that you’ll follow when reporting revenues and expenses. But what accounting method should you choose? Let’s review two different accounting methods: Accrual Accounting vs Cash Basis Accounting.
What is Accrual Accounting?
You need to report your revenue and expenses, but which accounting method is best for your bookkeeping needs? It may seem simple, but there are different methods that you as a business owner can choose. The first accounting method we will review is the accrual accounting method.
Accrual accounting is when you record a transaction when it is incurred rather than waiting for the payment to be received. In other words, as soon as a customer officially orders something from your business, that payment is noted, in this case you don’t wait until the order has been paid for. The accrual method records revenues and expenses when the money is actually spent or received.
This method can offer a more accurate picture of a company’s true financial state. This means that your bookkeeping will reflect not only what is in the bank, but also what is owed to you or what you owe.
Accrual accounting is when you record a transaction when it is incurred rather than waiting for the payment to be received. In other words, as soon as a customer officially orders something from your business, that payment is noted, in this case you don’t wait until the order has been paid for.
What is Cash Basis Accounting?
In this case, cash basis accounting may be the way to go. Cash basis accounting records transactions only when money is spent or received.
This is a popular accounting method, especially for small business owners. If your business has accrued more than $25 million in average annual gross receipts for the previous three years, you are required by the IRS to use the accrual method.
Key Differences Between Cash Basis vs Accrual Accounting
So now that you know what the accrual and cash basis accounting methods are, what are the differences between the two? Although both can be used to effectively and efficiently track your business’s finances, the key difference is in the timing of when revenues and expenses are recognized. Remember, the accrual method records revenues and expenses when they are incurred, not when they are received or paid.
Alternatively, the cash basis method simply requires you to record revenues and expenses at the time of paying or receiving funds. Each method has its advantages, but what is right for your business?
The Advantages of Cash Basis Accounting
As mentioned above, the cash basis accounting method is the more simple and more common accounting method used by many small businesses. There are a few advantages to using the cash basis method. For example, the cash basis method is simple and makes tracking your revenue and expenses fairly easy. This means that your accounting books will reflect the exact amount of money your business has at any time, which may be extremely important if you need to closely monitor your budget.
There are also tax benefits to using cash basis accounting. Specifically, using a cash basis method means you only pay taxes on the money you have received or paid rather than on purchase orders or invoices.
The Advantages of Accrual Accounting
Maybe you want to or need to use accrual accounting for your business. One of the benefits of using accrual accounting is that it can give you a more accurate picture of your business’s finances and performance, especially if you have outstanding purchase orders or invoices. This may also be useful when making strategic decisions for your business’s future. You know how much money you will have and how much money you owe.
There are also tax benefits when using the accrual method. For example, you can claim expenses on your tax form for the year you incur an expense rather than when you make a payment. Again, this may or may not be beneficial depending on your business’s financial outlook.
Should you Use Cash Basis vs Accrual Accounting?
Now that you understand the basic differences between the cash basis and accrual accounting methods, you may be wondering which method is right for you. Consider your business’s current or future finances. Do you need a simple method that is easy to track? Are there specific tax benefits that may be right for your company using one cash basis vs. the accrual method?
Take time and speak with your business partners and professional accountants about both methods and consider what may work best for your business.
Frequently Asked Questions
Still have questions about the different types of accounting methods and which one is right for you? Below are some frequently asked questions that may help you decide.
What is Accrual Accounting in Simple Terms?
Simply put, accrual basis accounting tracks your finances even if the cash is not in your bank account. When using accrual accounting, your current finances reflect what is in your bank account plus what is owed to you or what you owe others. This method may help you with planning future financial decisions and directions and may be required by law. if you make a certain amount of money.
What’s an example of Accrual Basis Accounting?
Let’s say that in your business bank account, you have $1 million, but you have a large purchase order from a customer amounting to $50 thousand. If you are using the accrual accounting method, as part of your bookkeeping, you would record this amount as part of your companies’ current finances. This means that your records would indicate that you have $1,050,000 available, even though the purchase order has not been fulfilled and the $50,000 is not in your bank account.
What is the difference between Accrual vs Cash Basis Accounting?
The big difference between accrual vs cash accounting is timing. You may need a simple and straightforward method for keeping track of the money currently in your bank account. In this case, cash basis accounting be right for you. Alternatively, you might have many purchase orders on the books, but payments are still coming in. Business should not stop because actual cash does not reflect your business’s true finances. In this case, accrual accounting may be the method you should use.
What is the Purpose of Accrual Accounting?
The purpose of accrual accounting is to match revenues and expenses to the period that they incurred. This means that you will have a more accurate idea of your company’s finances and may be able to make better-informed decisions about your company’s future directions.