One of the first decisions every business owner faces is choosing how to track his or her finances. The two main methods —cash accounting and accrual accounting—offer very different approaches. Don’t know which one you should use? Here’s a quick explanation:
What is Cash Accounting?
With cash accounting, you record income and expenses only when money physically moves in or out of your bank accounts. It is great for small businesses focused on managing cash flow.
Chances are, if you manage your home personal finances, you do it this way. You don’t base your decisions on the money you don’t have yet, but on what you DO have, with an eye towards future obligations.
Small businesses ($25 million a year or less over the last three years) sometimes do this. Businesses that are very cash-tight might use this, service-based businesses like consulting, freelancers, and law firms. Once you start getting inventory, however, then you get bills for supplies and people start using credit to buy from you.
What is Accrual Accounting?
With accrual accounting, you record income when it’s earned (even if the customer hasn’t paid yet) and expenses when your business incurs them. This method gives a clearer picture of your overall financial health, especially as your business grows.
So you see your bills on your balance sheet and profit and loss even if you haven’t paid them yet.
You see your invoices on the same statements even if you haven’t received any money.
At that point, accrual basis accounting makes more sense, because you need to see what you owe and what your customers need to pay you.
Want to learn more? This helpful article explains the differences in greater detail: Forbes: Cash vs. Accrual Accounting
What are Cash and Accrual – The Wrap Up
Do you have physical inventory? YES? -> Probably Accrual-based.
Do you pay for things in one year often to profit from them in the next year? YES? -> Probably Accrual-based.
Do you get paid for your services days after you perform them, or get paid in an unpredictable timeframe? YES -> Probably Accrual-based.
Does your business earn more than 25 million a year over 3 years? YES? -> Accrual-based.
Do you only get paid for services, which are usually performed and paid for same-day? YES? Cash-based can work.
Do you only sell what you make and inventory is very limited? Cash-based can work.
Are you a freelancer commissioned to do things with a long completion time, with payment milestones spreading from one year to the next? -> Accrual-based can work.
Let’s be clear. You CAN use either one; you just need to choose the one that best fits your business.
If you’re not sure which method suits your business or need guidance on bookkeeping, I’m here to help. Let’s save you time and money so you can do what you do best: your business! Call to schedule a free bookkeeping strategy call.
What method have you used for your business and why?
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