Posted by Richard Holbrook, MBA

Which Accounting Method is Right for Your Business?

Which Accounting Method is Right for Your Business?

When starting a new business, tracking expenses and income is a key part of the administration of your business affairs. However, it also means that you must choose what type of accounting method to use. Local bookkeeping or accounting professionals, such as Baystate Tax Service, can assist you in determining the best method for your business. Still, it is important to understand the basics of the accounting methods available. There are two types, accrual accounting and cash basis accounting. Let’s start with a quick introduction to each.

  • Cash Basis Accounting

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

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.

  • 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.

  • 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 based on their billing and payment cycle. 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.

Click on our link to connect with our accountants or tax professionals at Baystate Tax Service, to assist you in deciding what works for your business and how to set it up properly.

Richard Holbrook, MBA
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