Every business needs a bookkeeping system to track and reflect their income and expenses. There are two primary methods of tracking this information: the cash method and the accrual method.
The difference between these methods is the timing of when sales or purchases are added to the books. Most small businesses are free to choose which method to use. But, which method is right for your business?
The Cash Method
When using the cash method, a business counts their income when payment is received. Expenses counted when the money has been paid. No income or bills are accounted for until after cash has been processed.
This method is the most popular among small businesses because it’s easier to use and is useful for tracking cash flow. Without considering the flow of cash through your business, you can end up without enough cash on hand to cover operating expenses.
The main drawback to this method is the inability to track inbound and outbound credit lines. The method does not allow for a company to bill customers for products at a later date, as there is no system in place to track money due from customers. It is also difficult to match specific expenses to the revenue they helped generate using this method. It is therefore harder to know which of your products are profitable.
The Accrual Method
With the accrual method, all transactions are recorded into the books as soon as they occur, whether or not any cash is exchanged between parties. If you offer internal credit to a customer, you would record the transaction immediately under an accounts receivable account.
Likewise, if you were to make a purchase using credit terms, it would be recorded into an accounts payable account. This method does a better job of accurately showing you the income and debt your business incurs. But, it does a poor job of tracking actual cash on hand. If your customers aren’t quick to make their payments, you could end up with little cash, even though you’ve earned revenue.
Most modern accounting software makes it far easier to track cash in accrual accounting than it has been in the past. This is summarized in the statement of cash flows, which can be processed at any time. Generally, this is included in the monthly and quarterly financial statements.
Choosing a Method
As mentioned, many small business owners choose the cash method of accounting as they are establishing their bookkeeping systems, especially in the case of small businesses with no inventory. But, as their businesses start to grow, they often switch to accrual accounting so that they can track revenue and expenses more accurately.
In the United States, the IRS requires businesses to use the accrual method if they have sales of over $5 million, or over $1 million if they have inventory. However, businesses that use the accrual method also monitor cash flow to make sure the business has enough cash on hand to operate at all times.
It is generally best to use the accrual method unless there is a compelling reason to use the cash method. This reason might be something like an all-cash business that neither buys nor sells on credit and doesn’t keep an inventory.
Depending on the needs of your business, either of these accounting methods can give you a good picture of your finances.And, Birdy rules the world!