Most small business owners shy away from accounting like the plague and understandably so. Accounting can be tedious and not too exciting but even if you don’t handle your own financial reporting, it’s vital to know how the difference between cash and accrual accounting so you can choose the best bookkeeping practices for your business. Accounting methods are simply how to account for income and expenses and ultimately profit or loss and making an incorrect decision can lead to headaches down the road.
What is the Cash Method?
The cash method is the more commonly used method of accounting in small business. Under the cash method, income is not counted until cash (or a check) is actually received, and expenses are not counted until they are actually paid.
What is the Accrual Method?
Under the accrual method, transactions are counted when the order is made, the item is delivered, or the services occur, regardless of when the money for them (receivables) is actually received or paid. In other words, income is counted when the sale occurs, and expenses are counted when you receive the goods or services. You don’t have to wait until you see the money, or actually pay money out of your checking account, to record a transaction.
Choosing an Accounting Method
Most small businesses (with sales of less than $5 million per year) are free to adopt either accounting method. You will have to use the Accrual Method once your business has sales of more than $5 million per year, or your business stocks an inventory of items that you will sell to the public and your gross receipts are over $1 million per year.
Advantages and Disadvantages of the Accrual Method
The accrual method helps to better match income with expenses in terms of timing but it may leave you in the dark as to what cash reserves are available, which could result in a serious cash flow problem. For instance, your sales ledger may show thousands of dollars in sales, while in reality your bank account is empty because your customers haven’t paid you yet.
Advantages and Disadvantages of the Cash Method
While the cash method provides a more accurate picture of how much actual cash your business has, it may offer a misleading picture of longer-term profitability. Under the cash method, for instance, your books may show one month to be spectacularly profitable, when actually sales have been slow and, by coincidence, a lot of credit customers paid their bills in that month.
To have a firm and true understanding of your business’s finances, you need more than just a collection of monthly totals; you need to understand what your numbers mean and how to use them to answer specific financial questions. This is where a good bookkeeper or CPA will come in handy.
Once you understand your cash flow position, you can better plan for cash flow shortfalls due to slow collections or limited vendor terms. In these cases, an asset based lender such as FSW Funding, can help bridge the gap by providing capital.