Once you 've thought of a killer business idea, found funding, have begun hiring and have a good amount of revenue your next big decision will be to decide on what method of accounting your company should use. Is cash accounting or accrual accounting better for your business?
Let's say you have a huge contract for your thriving small business. But you won't receive the money until after your services have been rendered, let's say in March and you submit an invoice. Sometimes this payment process can take months; let's say you finally get paid in May.
How you record that money as revenue is the difference between cash and accrual accounting.Do you record it when you make the sale, when you deliver the services or when you receive the money?
In cash accounting, you only recognize revenue when you have it in hand, and you only record expenses when you have made the payment. In accrual accounting you record revenue when it's earned and expenses when they are incurred regardless of when the money is received.
Pros of Cash Accounting:
- Simplicity - This method is intuitive and straightforward; when money enters your account its revenue, when money leaves your account its an expense.
- Gives an accurate picture of how much cash is actually on hand (i.e. what's in your bank account).
Cons of Cash Accounting:
- Tendency to distort income and expenses.
- Limited ability to demonstrate how business is doing: sales, how much money is expected to come in, and how many expenses you need to pay.
- Better idea of company's profits. A more accurate account of revenue vs. expenses.
- Easier for you to to plan because you have accounted for all of your revenue and expenses (even if you haven't received payments yet).
- Avoids Overspending because you account for expenses you've incurred but haven't paid yet.
Cons of Accrual Accounting:
- More complicated than 'Cash Accounting'
- Can lose track of how much cash your company actually has on hand- accounts are removed from flow of cash.
Which Method is Best for Your Company?
Its always a good idea to converse with accounting experts to work out which method would best benefit your company. With that in mind here is a general break down of which method you should use.
If your business has sales under $5 million/year you can choose either method for accounting. If your company has sales more than $5 million/year you are required by the IRS to use the accrual method.
However, regardless of your yearly revenue, if your business keeps an inventory to sell to customers, you are required, again by the IRS, to use the accrual method for the inventory (i.e. sales).
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