Choosing accounting methods depends on a few things. The first system is the Cash Accounting Method which recognizes revenue and expenses only when money changes hands. Basically, there are no accounts receivables or accounts payable (more on this later). While the Accrual Counting Method recognizes revenue when it’s earned. Whether you get paid or not. And expenses are recognized when they’re billed. But not necessarily paid. These two are important to identify before you start your book-keeping (another word for accounting).
Accounting Methods: Cash
Pro’s
- It’s simple to understand
- Simplifies the bookkeeping process.
- Easy to track money flow in and out of your bank account.
- No income tax until you have the money.
Con’s
- Provides an inaccurate picture of your finances.
- Doesn’t account for all incoming revenue or outgoing expenses.
- Inaccurate view of monthly cash flows.
- Harder to track real business metrics like: gains, losses, write-offs, inventory, depreciation etc.
Accounting Methods: Accrual
Pro’s
- More realistic view of income and expenses over specific time periods.
- More accurate long-term view of finances and overall business practices.
- Greater diversity in dealing with taxation issues.
- Helps us better determined our overhead.
Con’s:
- More complicated for small businesses.
- Increases possibility of needing to hire professional help.
- Not true picture of cash flow (more manipulation opportunities).
- We are free to choose either if sales are less than $5 million per year, and if you don not keep inventory of merchandise to sell (then you need accrual).
Choosing accounting methods: questions to ask:
- Do you expect not to be paid sometimes? For example, will you have people owing you a lot of money (accounts receivable). Do you expect to extend credit?
- Will you owe or need to run delayed payment accounts to outside vendors (accounts payable)? Will you have a lot of inventory, or things that you may not sell and must write off? Do you plan on running ongoing tabs with suppliers?
- Will customers be able to return or get refunds at any time? For example, will you receive money down on deposit for work done beforehand? Like getting paid half down and half upon completion? This way if customers break contract, you can recoup losses due to deposits? If they made no payment before you began and they renege, you have to eat your loss using the cash method.
- Will you rely on retail inventory sales? Doing this requires you to use accrual due to the way inventory is handled.
If you answered yes to any of the first questions, then Accrual would probably be best. For those with a simple service company, which gets paid in advance, the cash method might be easier.
Here’s a simplistic example taken from Bench.co:
Imagine you perform the following transactions in a month of business:
- Sent out an invoice for $5,000 for a web design project completed this month
- Received a bill for $1,000 in developer fees for work done this month
- Paid $75 in fees for a bill you received last month
- Received $1,000 from a client for a project that was invoiced last month
Using the cash basis method, the profit for this month would be $925 ($1,000 in income minus $75 in fees).
Using the accrual method, the profit for this month would be $4,000 ($5,000 in income minus $1,000 in developer fees).
Learning from this example, the cash basis only records cash transactions (thus harder to write off losses if not paid later). Accrual is not really a true picture of cash transactions, but allows for better view for operational / managerial / financial practices of the company. Some small business use a combined system, but this is not recommended for a new business. When it comes to choosing accounting methods, you must do so by the end of your first year for tax filing purposes. It’s possible to change later if necessary, especially if you add payroll or expand inventory. After the first year in business its a good idea to start looking into understanding income, balance and cash flow statements. These provide the most useful financial information available to us.