While there are many decisions that you have to make when starting your new business, one of the most critical is the accounting method that you will use in your business. Once you start with a method, it can be virtually impossible to change to another method. Below is an overview of two major accounting methods, along with their pros and cons to help you determine which one will work for you!
What is the Cash Basis Accounting System?
When using this method, your business will be recording expenses when the funds are dispersed and income is added when it is actually received. Cash earnings will include checks, cash and credit card receipts. For example, if a service is performed in one year, but the payment is not received until the following year, the income is recorded in the year it was received. Essentially, the income counts when it becomes available for use by your business and not beforehand. Expenses are recorded in the same way. They are recorded when the expense is paid, not when the expense is initially incurred.
Accrual Accounting – What is Involved?
Accrual accounting is based on when work is completed and billed. So revenue is recorded when the work for a customer is completed, but not when the cash is received. Expenses work in the same way. They are recorded when the expense is incurred, even if the actual bill is not paid until a later time. Supplies purchased on credit are a great example of this type of expense. This accounting method is the generally accepted one for corporations, according to General Accepted Accounting Practices (GAAP).
Pros of Cash Basis
Cash basis excels at tracking the actual amount of cash you have available. It is also fairly simple to follow, so a business owner does not need to necessarily employ accounting staff to handle their bookkeeping. This is a method that many small businesses use because it is a fairly straightforward method.
Pros of Accrual Accounting
This is the best way to match up expenses and income on a monthly basis. This means that an owner can have a better idea of their operating costs and also to understand how much profit they are incurring, because these items are paired in the month they are initially incurred.
Payroll and Taxes
Each method records the payment of taxes in a different way. Keep in mind that taxes are incurred every month regardless of which method you choose. With the cash basis system, the tax expense for payroll or other taxes is not recorded until it is actually paid out to the government. This can mean that the company will shower a higher profit for two months every quarter, but a loss during the quarter when the taxes are paid.
With the accrual method, an expense for taxes is recorded each month. The funds are then transferred into an account for tax liability. The account needs to be tracked for payments actually made and those yet to be made. Therefore, the tax expense is matched to the account in which the expense was incurred but not necessarily when it was paid.
Cons for Cash Basis and Accrual Accounting
As we have discussed, cash basis accounting does mean you know exactly how much cash you have on hand at any given point. However, it can also mean that expenses and income are not matched on a month to month basis. Therefore, your profitability might be uneven throughout the year. However, using a cash basis can also mean reducing your tax burden by requesting payments of income be held off to the beginning of the following year.
Accrual accounting allows for the books to provide a more balanced view of expenses and income from month to month. However, jobs completed at the end of the year will incur taxes in that year, even if the actual payment is not received until the new year.
Each of these systems has the ability to track your expenses and income in a meaningful way. However, smaller companies have to decide the best way to determine how they will handle the tracking of their finances. A factor in deciding the best accounting method is how your business is classified. As we have mentioned, GAAP is considered appropriate for businesses that are incorporated.
In the final analysis, choosing the appropriate accounting method for your business depends on your end goal and how you want to demonstrate your profitability.
