Last month, I talked about the importance of knowing how to read your financial records. It’s hard to grow your business, if you can’t tell if your company is making money or losing money after all!
But maybe that doesn’t apply to you. Maybe you’ve got the financial records down, but you’re still struggling with whether or not to use cash-basis or accrual accounting. What’s the difference? How many ways can there be to keep track of your money?
Not to worry; here's a brief guide that will explain which system is right for your company or small business. (In a rush? Check out this 1 minute video.)
Don’t worry; it’s only slightly more complicated.
Cash Basis Accounting
Cash-basis or cash accounting is what many people think of when they think of “keeping records.” It’s the simplest way to keep a record of your expenses and profits.
The way cash accounting works is that you record each time you receive a payment or when you make a payment. So if you pay your electric company $100, you would record that expense. Conversely, if you received a payment from a client for $250, you would record that payment as well.
One benefit to using cash accounting is that it's simple. Additionally, it pretty much aligns with your cash flow. Finally, you won’t get taxed on cash that you don’t currently have.
However, cash accounting simply shows what’s in your bank account at the moment and doesn’t take into consideration how your business is doing in the long term.
For example, if you bill two clients for completed projects worth $1000, although you don’t have the cash in your bank account, you have the promise of $2000 coming later. Your bank account is empty, but (assuming your clients pay the bill at a reasonable time) you’re going to make a profit. Alternatively, if you have $2000 in your bank account, but owe $3000 in bills, your business isn’t making as much money as it looks like.
This may or may not be an accurate picture of your bank account.
Accrual Accounting
Accrual accounting is more commonly used by bookkeepers. In fact, the IRS even requires some larger corporations to use accrual accounting.
Accrual accounting works by recording payments when they are due rather than when they have been received. It’s similar to the “Pending” transactions that you see in your personal bank account.
So when you receive a bill from your electric company for $100, you would record that expense when you received the bill and NOT when you paid it. Alternatively, if you billed a client for $100, you would record that payment when you billed it and NOT when you got paid.
Besides being more complex, one downside of using accrual accounting is that it doesn’t accurately show your cash flow. For example, although you may have $2000 in pending payments, you might not actually have anything in your bank account.
Additionally, you can be taxed on “pending” income even if it’s not physically in your bank account.
Accrual accounting works best in tandem with accounts payable and accounts receivable. I’ll talk more about that in our next blog.
Let’s practice!
Practical Comparison
Over the month of July, your business does this:
- Received July’s electric bill for $100 on 7/31
- Made June’s loan payment of $250 on 7/14
- Sent an invoice for a $700 project on 7/21
- Bought a new computer for $500 on 7/7
- Received a payment for $450 for completed project on 7/18
If you were using cash accounting, you would calculate that you had a deficit of $300 for the month of July. (Project payment of $450 - [Loan payment of $250 + New computer for $500] = -$300).
Conversely, if you were using accrual accounting, you would calculate that you had a profit of $100 for the month of July. (Invoice of $700 - [Electric bill for $100 + New computer for $500] = $100).
In Conclusion
Neither method is wrong; however, cash accounting allows you to see the present situation more clearly and accrual counting allows you to plan for the future. Because small business finances can be tricky to understand, use the method that makes the most sense to you and will make it easier to run your business.
If you need help reconciling your accounts, M. Root Bookkeeping is happy to help.