Overview

You have undoubtedly heard the terms accrual accounting and cash accounting if you own a small business. Perhaps you were prompted to select one by your accounting software. Or perhaps a switch was recommended by your tax preparer. In any case, it's an important choice to comprehend.

To be precise, there isn't a single solution that works for everyone. Your business model, cash flow management strategy, and long-term objectives all influence the best accounting method.

Let's get right to the point.

Cash Accounting: What Is It?

The simplest approach is cash accounting. When you receive money, you record your income; when you pay a bill, you record your expenses. Just keeping track of what comes in and what goes out of your bank account.

For instance, on March 1st, you send a client an invoice. You get paid on March 15th. When the money reaches your account on March 15th, you record the income in accordance with cash accounting.




Benefits of Cash Accounting

  • Easy to handle and comprehend.
  • Gives you a clear picture of your available funds
  • It is effective for companies that have few big transactions or little inventory.




Cons:

  • It can provide a false impression of financial health if income or expenses are not received on time.
  • Doesn't keep track of accounts payable or receivable
  • Unsuitable for expanding businesses that require thorough financial monitoring.

Accrual accounting: What is it?

Although more complicated, accrual accounting is much more precise. Even if you haven't received payment yet, it records income as soon as it is earned and expenses as soon as they are incurred.

For instance, you submit an invoice on March 1st, but payment is received on March 15th. Since you earned the money on March 1st, accrual accounting records it on that date.

Benefits of Accrual Accounting

  • Provides a more realistic view of the financial status of your company.
  • Aids in matching income and associated costs within the same time frame.
  • Great for businesses that generate more than a specific amount of money (varies by country)

Cons:

  • More difficult to maintain (may need software or expert assistance)
  • Doesn't display the amount of money you have on hand.
  • Can result in cash flow surprises if not properly watched.




How Do You Make a Decision?

The way you manage your company will determine whether you use accrual or cash accounting. Here are a few examples to get you started:

  • Select cash accounting if you are a freelancer or sole proprietor.
  • You receive payment for your services right away.
  • You prefer ease of use to meticulous tracking.
  • You don't have to deal with lengthy payment cycles or inventory.
  • If you invoice clients and receive payment later, go with accrual accounting.
  • You have several vendors or carry inventory.
  • You're planning to expand your company or look for investors.
  • You're looking for a more comprehensive financial picture than just your bank balance.




Can You Switch Later?

Indeed! When things become more complicated, many businesses switch from cash accounting to accrual accounting. Just be aware that switching has an impact on how your taxes are reported for your income and expenses. To formally make the change, you might have to submit a form to your tax authority. It is advisable to consult an accountant before making a change.




Concluding remarks

Cash accounting may be all you need if you're just starting. Accrual accounting provides the information you need to make better decisions, whether you're expanding, managing invoices, or getting ready for funding.

In any case, being aware of the distinction gives you a sense of financial control, which is beneficial.

Blogged by: BDGAGSS