When you start a small business, there are a number of decisions you have to make. One of those decisions is what type of accounting method you are going to use in your small business. How are you going to record your financial transactions? You can use either a cash system of accounting or accrual accounting. Which method of accounting you choose depends on several factors. Outsourced accounting services for small businesses can also help you determine which method is most appropriate for your company.
As a small business owner, keeping an accurate account of your expenses is vital if you’re going to keep your business in the black, and it’s absolutely essential if you’re going to grow. The good news is that there are only two primary methods you’ll need to know: cash basis accounting and accrual basis accounting. Even if you don’t handle your own financial reporting, it’s vital to know how each one works so you can choose the best bookkeeping practices for your business.
The Cash Method
With the cash method, you record income when you actually receive payment from customers and have the cash in hand. Similarly, you record expenses when you actually write a check and the cash leaves your bank account. If this sounds familiar, it’s how people balance their checkbooks and manage their personal finances. It’s a simple accounting method that makes intuitive sense.
- Easy to Understand: Cash basis accounting tends to be simpler to understand than other accounting methods. If you choose to implement the cash method for your small business, it may not be necessary to seek the help of a professional accountant.
- Shows Cash Flow: The cash method most resembles a cash flow statement. It provides an accurate picture of how much cash your business actually has on-hand.
- Single-Entry System: The cash method can be done with a simple single-entry system, so a complex accounting program is not always necessary. This is, however, also one of its drawbacks, which is outlined below.
- Single-Entry System: While the simplicity of the single-entry system needed for the cash method is an advantage, it is also a disadvantage. The accrual method necessitates the use of a double-entry system, which is based on accounting equations. This system provides far greater control of transaction posting and reduces the chance of errors.
- Short-Term Indicator: While this method of accounting indicates the cash flow of a business, it may offer a misleading picture of longer-term profitability. The cash method doesn’t show income that has been invoiced but not received. Furthermore, it doesn’t take future expenses into account. It can also be misleading. For example, your books might show one month as being extremely profitable. However, deeper insight may reveal that sales were actually slow, but a number of customers paid their outstanding bills.
- Restrictions: According to the IRS, you cannot use the cash method if your business maintains inventory, is a corporation or has gross receipts in excess of five million dollars per year. These are the general rules, but there are exceptions — so if you feel that your business falls into one of these categories, you should consult a local CPA.
The Accrual Method
With the accrual method, income and expenses are recorded when they are obligated to be paid. In other words, if you make a sale, you record it as income on the date of the sale, not when you actually pay for it. And you record an expense the day you incur the expense, even if you don’t actually pay for it until a later date. Most experts agree that the accrual method gives you a better picture of your financial outlook because it accounts for money that flows in and out of your business.
- It provides an accurate picture of overall cash flow for the business: Many business transactions occur over a period of several months and therefore several accounting periods. Accrual accounting reflects that income and expenses generated in one month can carry over into the next month or even longer.
- Investors prefer accrual accounting: A business that uses accrual accounting is often looked at as more permanent and established than businesses that use cash-basis accounting methods.
- It’s the preferred method for GAAP: The Generally Accepted Accounting Principles set forth by the Financial Accounting Standards Board prefers accrual accounting over cash-basis accounting because the financial statements for a business that uses accrual accounting are deemed more accurate since the transactions reflect when they actually took place instead of when money is exchanged.
- Small companies might lack the staff needed to manage this method: Larger companies typically have staff – even an entire department – dedicated to tracking and reporting transactions. For example, a hospital might have an account receivables department to keep track of patient billings, and an account payable department to track hospital expenses.
- Accrual basis accounting requires at least monthly reporting: In order to remain accurate, accrual accounting needs frequent reports generated. These are usually the monthly financial statements most business managers are familiar with, such as the income statement and balance sheet. But accounts receivable and accounts payable reports are often generated on a more frequent basis. Outsourced accounting services can help generate monthly reports if your business prefers this method.
- Taxes: Although an advantage to using accrual accounting is that you can report income when the sale is incurred instead of waiting until you have cash on hand, this also means a business pays taxes on money it hasn’t received. We advise consulting with a local CPA for tax assistance if you are unsure of your tax obligations under the accrual accounting method.
How To Choose
You’ll need to choose an accounting method when you file your first tax return and then use it consistently on all subsequent returns. A trusted CPA can help you determine which accounting method is best for your business. Outsourced accounting services can also best advise your business on a method and set up accounting software to reflect it. It is important to note that in order to change accounting methods, you need to file Form 3115 to get approval from the IRS.
Limitless Investment and Capital’s Outsourced Accounting Services
When you outsource your accounting with Limitless Investment & Capital, you gain more than time back. You will save money over time compared to an in-house bookkeeper, as well as gain the support and knowledge of the entire Limitless firm. Our CPAs can help your small business what accounting method suits your business best for cash flow management, taxes, and success. Your accounting records will have multiple sets of eyes to ensure zero errors. Get in touch with a local CPA today!