Whether you own a small company or a large corporation it is important to maximize the value of your accounting records so you can make the most informed and appropriate decisions for your business. The accounting method your company uses can have an impact on your ability to make these financial decisions, so it is important to choose the best method for your business.
There are two primary accounting methods that companies use to track their income and expenses – cash basis or accrual basis accounting methods. Below we will review the advantages and disadvantages of each accounting method, discuss the impact they could have on your company, and assist you in evaluating which method is the most appropriate for your business.
Here are some important criteria to consider when performing this evaluation:
- Who are the users of the financial statements and information (management, investors, bank, tax advisors, etc.) and how will they use this financial information?
- What method of accounting is the company using for tax purposes?
- What is the vision of the company in the next 5 years?
Cash Basis Method of Accounting
With the cash basis method of accounting, transactions are accounted for based on the company’s cash inflows and outflows. For example, revenue is recorded by the company when the cash is received from customers and expenses are recorded when payments are made to vendors. Because all transactions are recorded based on the cash inflows and outflows, the company’s balance sheet will not include, or track, the accounts receivable or accounts payable. With this method, accounts receivable and accounts payable are usually tracked separately within the company’s accounting system or on the side.
Many small and start-up companies will use the cash basis accounting method because it is typically the simpler of the two methods from an accounting standpoint. At this point in a business, companies also tend to place a lower level of importance on the financial information of the company, so the cash method is sufficient for their purposes.
Accrual Basis Method of Accounting
Under the accrual basis method of accounting, transactions are accounted for when the transaction occurs or is earned, regardless of when the cash is paid or received. Income is recorded when the sale occurs and expenses are recorded when the goods or services are received.
Although it is slightly more complicated from an accounting and tax preparation standpoint, there are significant advantages for companies using the accrual accounting method. These advantages include:
- The ability to “match” revenues and related expenses within the applicable periods so companies can appropriately analyze profitability margins.
- Creating consistency as to when the revenues and the expenses of the company are recorded allowing for increased ease of budgeting and forecasting.
- If the company is looking for additional financing opportunities, banks and other investors usually ask for the financial information in the accrual basis method of accounting.
In general, the accrual method of accounting provides a better picture into the financial results of the company. This allows users of the financial information to make more informed decisions, ultimately providing additional value to the company.
Which Accounting Method is Best for Your Business?
Based on the information above, let’s revisit our consideration questions to help you evaluate which method is best for your business.
1. Who are the users of the financial statements and information (management, investors, banks, tax advisors, etc.) and how will they use this financial information?
If the users of the financial information are strictly internal management and there are a limited number of transactions, the cash method may be appropriate; however, management will be limited to the financial information available when making decisions.
If the company has outside investors, bankers, or other advisors, it is highly recommended to utilize the accrual method. Not only will it provide substantially more insight and value to those users, it will also show that the company is sophisticated enough to take the next step as a company.
2. What method of accounting is the company using for tax purposes?
From a tax perspective, the accrual method MUST be used for the following companies:
- Your company is a C corporation.
- Your company has inventory.
- Your gross sales revenue is greater than $5 million (there are some exceptions to this rule that you should discuss with your tax accountant).
If your company is required to report taxes on an accrual basis for any of the reasons above, then you should always account for your internal records on an accrual basis as well.
If your company does not meet the above criteria, then you have the option to report taxes on a cash or an accrual basis. Many times it is more advantageous to report taxes on a cash basis and these options should be discussed with your tax accountant. However, even if the cash method is the best option from a tax perspective, it may still be beneficial from a management perspective to use the accrual method for internal reporting purposes.
3. What is the vision of the company in the next 5 years?
If your company is small, has limited transactions, and there are no plans for growth in the future, then the cash basis method of accounting would likely be the preferred and most reasonable option.
However, if your company forecasts growth in the future, especially if you plan to have revenues in excess of $5 million, it is important to begin accounting for the company’s transactions on an accrual basis as soon as possible. This transition is essential as you prepare your company to enter into discussions with other advisors and begin seeking out potential financing opportunities. It will give your company and management credibility and allow you to make the most appropriate and informed financial decisions for your business.
Making the Transition
If your company is currently using the cash basis method of accounting and feel it may be time to transition to an accrual method, we can help. Our experienced accounting team has assisted several companies with this change – some to facilitate the growth of their business and others to provide better insight into the financial health of their company.