The full financial picture of a company is complicated. But proper accounting is essential for the financial health of your business and its overall potential for longevity. Not every method works for every business, so it’s valuable to understand your options. This starts with the way you record your income and expenses.
Read on to discover more about two popular methods of business finance tracking: the cash and accrual methods. We’ll also help you decide which one might be right for your company.
What Is Cash Accounting?
If you’ve ever balanced a personal checkbook, or typed what you’ve spent and earned into a spreadsheet, then you already have a pretty good idea of how cash accounting works. When a business uses this method, it tracks income when it is actually received, and expenses when they are actually paid.
So if a client is invoiced on March 1 and the check from that client is cashed on March 10, the income is recorded on March 10. If a client never pays, the income is never recorded. Expenses operate in the same way. The internet bill is not recorded when it arrives. It doesn’t make its way to the digital or literal accounting books until the business owner or administrator has paid the expense.
This method accounts for what comes in and what goes out in real-time, based on the payments that have been made. If you’re concerned about overspending and want to know exactly how much cash you have on hand at any given moment, the cash accounting method might be a good fit for your business.
Some companies are restricted from using the cash accounting method, however, so it’s important to speak to an accounting professional to identify whether it’s a viable option for you.
There are also tax benefits to cash accounting. Finance and accounting professionals will work with your tax personnel to determine the most advantageous method for your situation.
What Is Accrual Accounting?
Accrual accounting takes a more hypothetical approach to your big-picture business finances; accountants or financial firms count income when it is billed and expenses when they arrive.
If applying that to the example above, the client invoice would be recorded as March 1, even if it isn’t paid until April 1 or later. That internet bill is an expected expense the day it is received.
In the accrual method, accounting professionals will use a balance sheet to record the offsetting asset or liability so you can maintain a good sense of your business’ current financial status.
Accrual accounting is more intuitive to what’s happening next in your business, and not completely confined by the moment. With accrual accounting, you have a better sense of your cash flow needs because know how much to anticipate receiving in the short term — even though it’s not in your account yet — as well as your outstanding expense liabilities that are due. Financial professionals will usually add another reporting function that lists actual cash available at any given time.
Which One Should I Pick?
Other than personal preference, there are a few factors to consider when deciding if you want to use cash or accrual accounting methods. Keep in mind that:
- The size and type of company you run are major determining factors — for instance, all corporations (excluding S corporations) that generate over $5 million in gross annual revenue are restricted from using cash accounting.
- Businesses that keep inventory to sell to customers must use the accrual method when it comes to that inventory. This is an Internal Revenue Service requirement. In some cases, businesses apply the accrual method to their inventory, while the cash method is used for other expenses and income.
- The accrual accounting method is more difficult to report from a tax perspective — though financial service experts can easily handle this aspect.
- Cash accounting doesn’t give you much insight into your overall business health as far as sales, expected income or expected expenses go.
This handy overview can help you decide how to track your company’s income and expenses. But your bottom line is too important to track haphazardly, with the wrong method or not even at all.
Hiring a reputable financial firm will help you reduce the risk of spending too much, or straining vendor/contractor relations with late payments. Financial experts can also give more insight into which type of accounting method makes the most sense for your business needs. They’ll even set it all up for you so that you can keep focusing on the most important thing: running your company.