If you are a small business owner, you have probably pondered the method of tracking of your bookkeeping records. There are two methods to maintain your company’s books, which are cash or accrual basis of accounting. There are pros and cons to each method.
Cash Basis of Accounting
What is Cash Basis?
- Revenues are reported on the income statement in the period in which the cash is received from customers.
- Expenses are reported on the income statement when the bills are paid out.
Cash basis is a simplified process of bookkeeping. It is easy to track the ins and outs of your checking account. It gives a good picture of cash flow in your company. For very small businesses or if you are just getting started it is easy to keep track of how much money you actually have left for any growth.
For taxes, it is a great way to report your income on your tax return. The company only has to pay taxes on the amount of money you actually received. For example, a client is invoiced in November and you do not receive the money until January. In this case, you would not have to include the income on your tax return until the next year.
While the cash basis might be easier because of its simplicity, it is hard to see how your business is doing with costing expenses against the sales for the business. One month you might have a huge influx of cash because you received the cash for last month’s sale.
The other drawback is not recording the accounts receivable or accounts payable information. There would be no dates of sale or how much expense was directly related to that sale.
Accrual Basis of Accounting
What is Accrual Basis?
- The accrual basis gives a much better picture of the company’s profits for each accounting period.
- Revenues are recognized in the income statement in the period when they are earned. This usually happens before the cash is received.
- Expenses are recognized in the income statement in the period that matches to the income being earned. Usually the revenue and expenses hit the checking account at different times.
- The accrual basis of accounting gives a much better picture of how your company is doing at the end of the year. The accrual basis is required because of the matching principle of accounting.
Accrual Basis unlike cash basis lets you see a more long-term view of how your company is doing. Accrual basis is set up to match the income with the actual expenses that generated the revenue providing a clearer gauge of when your company speeds up and slows down over the course of a specific period.
Accrual basis of accounting conforms to the national accounting procedures, which are Generally Accepted Accounting Procedures (GAAP).
The accrual basis has its advantages but it does have some drawbacks as well. The most commonly cited is its more complex method of bookkeeping and its inaccurate portrayal of a company’s short-term cash situation.
Because the accrual method adds complexity and paperwork, many small business owners view it as more complicated and expensive to implement. The company revenues have to be realized before the money is received. Because of this complication, a separate schedule of cash flows is required to be able to plan for the short-term expenditures.
No matter which method you choose to track the income and expenses of your business. You should ask your accounting professional for help in assessing your business and which is best in the long run.