Keeping accurate accounts as a small business takes two major forms; accrual accounting and cash basis accounting. Both account types have benefits for either long-term or short-term purposes. One helps to track immediate account status while the other gives comprehensive account status spanning months. Let's examine each of these accounting options.
What is Cash Basis Accounting?
In the cash basis accounting method, income is recorded when received and the same applies to expenses. For example, if a laundry business renders a service and gets paid $200, the amount will be recorded only when the money is received. Account basis doesn't take the amount payable into account rather only received income.
So - if a business invoice a client in February but payment was received in March, the record of cash basis will document the payment for March. The same principle applies to expenses. If the same laundry business as cited earlier purchases laundering tools and essentials, the amount spent will be documented as expenses only when the items purchased as paid for.
If you own a small business, cash basis accounting is ideal especially if income falls below $25 million.
Benefits of cash base accounting
Cash basis accounting eases the bookkeeping process and allows businesses to track their account activities. Income and expenses out of the business account are tracked easily.
Disadvantages of cash base accounting
Cash basis accounting has a couple of downsides. It can portray a misleading business financial situation since it reveals only immediate cash flow. If an investor wants to assess a business, the immediate information based on the cash basis record may indicate a high cash flow while there is a huge payable amount. On the other hand, a cash flow may reveal low cash flow but a business may have huge receivables.
What is Accrual Accounting?
Accrual accounting provides a long-term overview of how a business is doing financially. It looks at the cash flow of a business beyond a quarter and is certainly not based on immediate cash flow. It provides a clear financial picture of a business because it shows account receivables and payables. In this method of accounting, expenses incurred in a month are recorded for that month and not when payment is made.
For example, if a business invoices a client in November but receives payment in December, the income is recorded in November, not December. The principle applies to expenses as well. Purchases made on credit in November are recorded as expenses for that month not when the payment was made.
Benefits of accrual accounting
Bookkeepers and business owners can use accrual accounting to get a realistic status of a business. It shows long-term income and expenses to facilitate proper planning. If you run a company with over $25 million annual income, accrual accounting would suffice. Although it would require complex bookkeeping, you'll get a vivid picture of what your business account looks like.
Disadvantages of accrual accounting
The disadvantage of accrual accounting is the intensity of the resources needed to keep an accurate record. Cash flow needs to be tracked over a long period. Unpaid receivables and expenses must be recorded from month to month. Usually, records from the accrual accounting may create an inaccurate account status. A business may have enough money on paper but below what is required to run day-to-day activities or emergency expenses.
Cash Basis Accounting vs. Accual Accounting
If you run a business with annual sales below $25 million, you may want to adopt any of the two accounting methods. You can use cash basis accounting to track immediate expenses and income, then use accrual accounting for a long-term business assessment. However, you must maintain one account officially to report taxes to the IRS for each tax year.
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