Cash and accrual accounting methods each have advantages and disadvantages, but once you pick a particular accounting method, it is important to apply it consistently. So how do you know which accounting method is best for your business? If you’re going to be tied to the method of accounting you choose, you want to make the optimal choice. This guide offers an overview of each accounting method and advice to help you choose the best one for your small business.
[Related read: Difference Between Accounts Payable and Accounts Receivable]
Cash accounting is the simplest and most basic method of accounting and focuses on cash inflows and outflows. It is predominantly used by individuals for personal accounting, as well as by small businesses.
In a cash-based accounting system, revenues and expenditures are recognized only when money is exchanged, irrespective of when goods or services are delivered. This means this method does not introduce the additional complexities of accounts payables, receivables, or current assets and liabilities. [Check out these nine accounting tasks you should do every day.]
This also means that any sales or expenses aren’t reflected in the financial statements until the amount is realized, and investments in inventory are shown as expenses until they can be sold for cash. With cash accounting, it’s more difficult to accurately assess your business’s financial performance.
For small businesses, cash-based accounting offers plenty of advantages.
Cash-based accounting comes with some clear disadvantages, making it unsuitable for certain types of businesses.
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Used in most professional organizations and businesses around the world, accrual accounting recognizes income only when goods and services are delivered, and expenses are recorded when they are incurred. [Read related article: Choosing the Right Small Business Accounting Software]
For example, if you were hired to construct a house, you would record revenues from the project as it was completed, irrespective of when the customer paid the money. The same applies for expenses, which are reported when they are incurred, not when you pay them.
Accrual accounting matches revenues and expenses to the same time period, allowing for a more accurate assessment of a company’s profitability and financial performance. It also uses double-entry accounting with accounts for receivables, payables, and inventories.
While accrual accounting is indispensable in modern businesses, it does have its shortcomings, such as a steep learning curve and greater complexity that can be a burden for small business owners. If you use accrual accounting, accounting software solutions and professional accountants are a necessity.
Another key drawback is the disregard for cash and payments, which can create cash flow issues. That’s especially true when coupled with tax liabilities, which are based on sales and income before the payment is made.
[Related: Difference Between Net and Gross Income]
The accrual system has undeniable advantages for businesses of all sizes.
Accrual accounting allows managers and business decision-makers to see a clear picture that is often missing from cash-based accounting.
Despite the undeniable benefits and widespread adoption in business, the accrual system has certain drawbacks.
With this side-by-side comparison, you can see the option that best suits your requirements.
|Revenue recognized when cash is received
|Revenue recognized when earned on delivery of goods and services
|Expenses recognized when paid with cash outflow
|Expenses recognized when incurred, irrespective of actual payment
|Keeps track of cash inflows and outflows to report financial performance
|Keeps track of receivables, payables, inventories and depreciation to report performance
|Tax liabilities only on money received
|Tax liabilities may arise even before money reaches the account
|Simple, easy to use, and requires no additional tools or professional help
|Involves a learning curve, requires accounting tools and professional assistance depending on the complexity
|Not accepted by banks and investors
|GAAP compliant and universally accepted by banks and investors
|Best suited for freelancers, sole proprietors, and independent consultants or contractors
|Required for businesses of all sizes with inventories, staff and assets
Accounting, financial management and reporting may seem overwhelming at first; however, there is a vast array of accounting solutions with easy-to-use, intuitive interfaces. You’re free to hire an accountant, but software also allows you to maintain your books professionally without outside assistance.
With high-quality accounting software that offers different features, capabilities, and pricing to suit businesses of all sizes, running a company has never been easier. You can even do accounting from an app on your mobile phone with most leading solutions. Learn more about individual accounting software solutions available on the market in our QuickBooks Online review or our FreshBooks accounting software review.