For most small business owners, making sure customers pay you on time and that your bills and taxes are covered, pretty much sums up your top-of-mind concerns when it comes to day-to-day accounting. And yet, there’s a very important question that underlies your entire accounting process…one that impacts all of these issues from the start.

That question is: Should the accounting be managed on a cash basis or accrual basis?

Understanding Cash Accounting

The key to cash-basis accounting is that it tracks money based on how cash actually moves. Put another way, you record each transaction on the basis of when cash actually changes hands (for example, when payment is received by the company or when funds are paid out by the company). The cash receipt or payment can be in any payment format (check, credit card, EFT or, of course, actual cash).

Advantages of Cash Accounting

Many companies begin with cash-basis accounting because it’s the easiest approach to administer accurately. In addition, it does an excellent job of tracking cash flow because you’re viewing the books specifically in terms of where cash actually resides inside or outside the company.

Disadvantages of Cash Accounting

At the same time, cash-basis accounting is not very effective at aligning revenues earned with money spent for expenses. This becomes more acute the longer the amount of time that passes between relevant transactions.

For example, if your company receives funds from a customer for a new project in one month, but your costs associated with most of that work (whether internal labor or purchased products/services) won’t be incurred until months down the road, cash-basis accounting can give you a false impression that profit in a given period is unusually high, when in reality most of those funds will be consumed in a subsequent period on delivery of the project.

This is why, in most cases as the business grows, you may find it necessary to switch to accrual accounting in order to more effectively manage revenues and expenses.

Understanding Accrual Accounting

While it may at first appear that cash accounting is the most “accurate” form (after all, what could be more clear than recording transactions when cash actually changes hands?), the reality is that accrual accounting provides greater precision because with the accrual method, you record all transactions when they actually occur.

Going back to our previous example: Instead of only showing the receipt of the deposit payment from the customer and not reflecting costs incurred against that revenue until one or more months later, the accrual method will show both sides right away.

Chances are, as soon as you receive a signed contract and a deposit check from the payment, you’re allocating internal resources and signing purchase orders for outside services or products to deliver against the project. Even though you haven’t paid those bills yet, the expenses are real and you benefit from knowing about them sooner rather than later. With accrual accounting, that is what happens.

Advantages of Accrual Accounting

The first advantage of accrual accounting is visibility. Because it keeps you informed at all times about every known payable or receivable (even those where a cash transaction has not yet taken place), you have a clearer picture of your profit and loss.

Disadvantages of Accrual Accounting

The greatest disadvantage of accrual accounting is that it is more complex to set up and administer accurately. The second disadvantage is that, although it is excellent and matching revenues and expenses, accrual accounting is less effective at tracking and monitoring your actual cash position.

For example, if you deliver a lot of products or services this week, you’ll record the revenue associated with those actions right away, even though the actual cash has not yet been collected. That means that it’s possible to show a high amount of revenue in the company even if the bank account is running dry.

Deciding on the Best Accounting Method for Your Business

The most important thing to note is that a decision about your accounting method today does not mean that you’ll stay with that method forever. Many companies start with the cash method and then transition to the accrual method as they grow.

Another major factor involved in selecting an accounting method is how your business taxes are calculated, which of course can impact tax deductions as well. The cash method limits you to deducting expenses when cash is actually paid, rather than when you incur the expense.

Also, if you do start with or convert to accrual accounting, make sure that you put in place regular cash flow monitoring and reporting processes (many companies do so weekly) to ensure that you’re covering both profit and loss, as well as cash flow.

GAAP (Generally Accepted Accounting Principles) recommends the use of accrual accounting. Generally speaking, most small service businesses use the cash accounting method for its simplicity. However, many retail and product businesses opt for the accrual method, because of its essential role in supporting tracking between product receiving, inventory management and sale/delivery to the end customer.

Also, keep in mind that IRS rules may impact your selection of an accounting method, so make sure to discuss options in detail with your CPA before choosing one for your business.

For more information and advice on how to select and implement the best accounting method for your business, consult with the team at Haines & Lagerquist CPAs by calling 301-249-0703 or via email to cpa@hainesandlagerquist.com.

Selected Sources:

Deciding between Cash-Basis and Accrual Accounting
http://www.dummies.com/how-to/content/deciding-between-cashbasis-and-accrual-accounting.html

Cash vs. Accrual Accounting: Learn which accounting method is better for your business.
http://www.nolo.com/legal-encyclopedia/cash-vs-accrual-accounting-29513.html

Cash vs. Accrual Accounting for Small Businesses
http://smallbusiness.findlaw.com/business-finances/cash-vs-accrual-accounting-for-small-businesses.html

Image Credit: 68751915@N05 (Flickr @ Creative Commons)