Whether you’re managing your bookkeeping in-house, or are considering outsourcing it, it’s important to understand the difference between cash and accrual accounting, so you can make a wise decision about which method to use. The main difference is really all about timing, that is, at what point in time your income and revenues are recorded.
Most small businesses use the cash method of accounting. This means that you record payments you receive and expenses you pay out as they happen. This keeps things simple, and you always have a clear snapshot of your finances at any point in time.
Using the accrual method differs in that your transactions are not booked when the funds change hands. Instead of recording a payment from your customer on the day you receive the money, that payment is recorded on the day that you complete the job. Similarly, payments you issue to your vendors are recorded on the day that you receive the services or products, rather than waiting to record these when you send the payment.
Why would you choose either the cash or accrual method over the other?
Cash accounting is simpler, and requires less effort and expense to maintain. You, or your bookkeeper, will simply record the transactions at the time they occur. It’s easier, there’s no question.
Cash accounting also always gives you an accurate view of how much cash you actually have on hand. A quick glance at your bank account tells the whole story, without the need to track payables and receivables. Your income also is not taxable until the money is in the bank, which generally works to your advantage.
Accrual accounting, on the other hand, gives a more accurate picture of your income and expenses during a specific period of time. This is more of a long-term view of your business, and gives a better view of your company’s financial health.
Using accrual accounting, if you do a job in November, but don’t receive the payment for it until January of the following year, the income is still booked in November. This method helps you with longer-range planning, because you’ve already accounted for money due to you (as well as payments you need to make) even if the funds haven’t yet changed hands.
It’s not always easy to make the decision of which method to use, and it’s best to get some professional accounting advice on this matter. Generally speaking, though, small businesses can choose either method, while businesses with revenue over $5 million are required by the IRS to use the accrual method. If you maintain inventory, the IRS will again require that you use the accrual method.