So, you’ve formulated your plan for a business, things are getting rolling, and you’re beginning to see some revenue. You may have invested in some financial software by this point too. But before you can start managing your books, you’re going to need to make a decision: whether to use cash or accrual based accounting. These are two terms that you may be hearing mentioned a lot, especially if you’re talking to bookkeepers or accountants.
The key difference between these two methods of accounting is simply about when you record your cash transactions.
Cash accounting means that your transactions are recorded at the exact time at which money actually changes hands. Your entries in your financial records will be made whenever you receive payment for work that you’ve done. And it works the same way for funds that you pay out to your vendors. You’ll enter those transactions in your books on the day you make the payment.
So, if you sell your goods or perform services for your clients, the income will be recorded whenever you get paid. If you’ve got a big contract with your client, with payment due upon completion of the work, you’ll enter that revenue in your books when it’s paid, even if you started the work in an earlier month or year.
Cash accounting is used by most small businesses. It’s easier, and it’s simple to know when to make your ledger entries. It makes it clear to see your cash flow, but not so easy to see the bigger picture of your income vs. expenses on particular projects, particularly when you buy materials or products up front, but don’t get paid for them until months later.
Accrual basis accounting takes the opposite approach. Transactions are recorded in your books when they occur, even if no moneys change hands at that point in time. If you buy or sell on credit, the income or expense is entered at the time of the sale, even though you may not pay or get paid until months later. So, accrual accounting is much more effective at matching up income and expenses. But it’s not so great at keeping track of your current cash. Since you’re recording transactions before you get paid, your balance sheet may look great based on the amount of receivables you’re waiting for, though the money may not actually be in the bank yet.
Which method is right for you? If you’re at the point at which you need to make a decision, it’s probably best to consult with an accountant who can give you some professional advice. You’ll need to make your choice between cash based accounting and accrual based accounting when you file your first tax return. Generally speaking, startup businesses tend to use the cash method, because it’s better at showing your cash flow, which is of paramount importance for a young business. Do keep in mind that if you show revenue of over $5 million a year, or if you maintain inventory of products, the IRS will require you to use the accrual method.