Should you use the cash or accrual basis for your business? If you are a small business owner, understanding your finances is vital, even if you allow an accountant to handle them for you. One of the most important aspects of accounting you need to understand is the difference between two accounting methods: cash and accrual. If you have never really paid much attention to accounting before, you might not know much about these methods, so we are going to take a better look at each.
The cash accounting method is the most intuitive method to use. As you receive money, you record it as income, and as you spend money, you record it as an expense. You do not worry about accounts receivable or accounts payable since you only record transactions where the money has already changed hands.
So, let’s say you complete a job for a client January 25th and you give the client 15 days to pay. The client pays you on February 2nd; you will then record this as February income, not January income. Essentially, what matters is when you get paid, not when you submit work and not when you reach an agreement to complete the work.
So, what are the benefits to this method? The first is that it is very simple to do, making it easier on those who are doing their own accounting but aren’t accountants. Another major benefit is that you do not pay income tax on money you have yet to receive. The primary drawback is that it can make it difficult to tell which months were good months since your income for work completed in one month can be recorded in another.
In essence, this is simply the reverse of the cash accounting method. With this method, you record your income when it is earned, even if it has yet to be paid, and your expenses on the date of the transaction, even if it has yet to clear your account.
So, going back to the example above, let’s say you complete a job on January 25th and you give your client 15 days to pay; your client ends up paying on February 2nd. You would record this as income for January when using the accrual method of accounting.
The biggest plus side to using this method is that you can see very clearly what your efforts for each month earned you. There are a few downsides. The first is that it is kind of like counting your chickens before they hatch; you can feel tempted to spend money you do not have yet, and what if the client doesn’t pay? Another problem is with work completed at the end of the year. In the example above, change January to December and February to January and you might run into a problem with taxes.
Ultimately, both methods work for small businesses, but if you are doing your own accounting, the cash accounting method is likely best due to its simplicity.