When it comes to accounting, there are two main methods used to record income and expenses: cash basis and accrual basis. The main difference between the two lies in the timing of when income and expenses are recognized. With cash basis accounting, income and expenses are recognized when money changes hands, while with accrual basis accounting, income and expenses are recognized when they are invoiced (but not necessarily paid).The key difference between the two approaches is time. Cash accounting documents profits when you receive them and expenses when you pay them.
However, the accrual method accounts for profits when they are due and expenses when they are due; it doesn't matter when the money enters or leaves your account. This is important, as receiving or sending payment isn't always immediate.Most companies should use accrual accounting as it is more accurate and, if you're managing inventory, it's the method the IRS requires you to use. With cash-based accounting, you won't record financial transactions until the money leaves or enters your bank account. With accrual accounting, you'll record transactions as soon as you send or receive an invoice, not when the money changes hands (virtual).Accrual accounting requires more effort to understand, but it more accurately represents the financial health of your company over time.
However, since the accrual method doesn't strictly control your cash flow, that particular task is up to you. A company may appear profitable in the long term, but in reality it has a significant and difficult shortage of cash in the short term.The Tax Cuts and Jobs Act increased the number of small business taxpayers who were entitled to use the cash accounting method. So it might make sense for a small business to start with the cash-based approach and change when the company requires greater responsibility.To get a more accurate and up-to-date accounting view of your financial health, accrual accounting might be the best option. Learn about the pros and cons of each accounting method below and decide which one is right for you.
Advantages of Accrual AccountingAccrual accounting offers several advantages over cash-based accounting.
Here are some of them:
- It provides a more accurate picture of your company's financial health over time.
- It allows you to track accounts receivable and accounts payable.
- It helps you plan for future expenses.
- It allows you to track inventory levels.
Disadvantages of Accrual AccountingAccrual accounting also has some drawbacks:
- It can be difficult to understand.
- It doesn't provide an accurate picture of your company's current cash flow.
- It requires more effort to maintain.
Advantages of Cash AccountingCash-based accounting also has some advantages:
- It's easier to understand than accrual accounting.
- It provides an accurate picture of your company's current cash flow.
Disadvantages of Cash AccountingCash-based accounting also has some drawbacks:
- It doesn't provide an accurate picture of your company's financial health over time.
- It doesn't allow you to track accounts receivable or accounts payable.