OK it’s time to get real, how often have you said or thought any of these:
Do I really need to be concerned about what kind of Accounting I do?
I mean I record everything, isn’t that enough??
What in the world is the difference between Cash & Accrual Accounting?
How does it affect me?
I know I often hear this from Small Business Owners and I can totally understand their point.
Cash Accounting seems easy & cheap. It’s basically just like a checkbook, money comes in and goes out.
Accrual Accounting comes across as confusing and overwhelming. It is especially so if you do not use the right software program and when you get into inventory and assets, and since you really need a good accounting system it can seem like the more expensive option.
In essence, the big difference between Cash & Accrual Accounting comes down to timing, specifically when Revenue & Expenses are recognized.
Recognized?? What the heck does that even mean??
In Cash Accounting you recognize Revenue & Expenses when the money actually changes hands. So if you send an invoice out on Sept 1st and receive the payment on Oct 15th, the Revenue is recognized on Oct 15th, the day you received the money. Similarly if you receive a bill on Mar 5th, then pay it on April 10th the expense is recognized on April 10th, the day you sent the money out. Again, it is about when the actual money changes hands.
In Accrual Accounting you recognize Revenue when it is earned & Expenses when they are billed. So like in the previous example, you send an invoice out on Sept 1st and receive the payment on Oct 15th, however with Accrual Accounting the Revenue is recognized on Sept 1st since that is when you performed the service or sold the product. Similarly you receive a bill on Mar 5th, then pay it on April 10th in Accrual Accounting the expense is recognized on Mar 5th since that is when you presumably received the service or product.
Before we hear from the peanut gallery, yes there are other elements and accruals, etc., but for our purposes here of looking at the broad definition of both systems this works. If you want to know about the nitty gritty then congrats, you are probably an accountant or in finance and probably don’t need to be reading this anyways.
OK, back to the topic at hand….
Now you are thinking “Great, that’s awesome, but how in the world does that affect me & my business?”
Well in truth it does and it doesn’t because if you use any form of accounting software or have a bookkeeper or accountant you are probably already using Accrual Accounting, which is exactly what you should be doing.
Cash Accounting is really only useful for very small basic businesses. While it is simple to use and lets you easily see your day-to-day cash status (again like a checkbook), it really is not an accurate picture of your business. Since money is only recognized when it changes hands your cash may be very high or very low depending on what revenue you have received and what bills you paid.
Once you get into any kind of producing, selling, or purchasing of merchandise or if you invoice with any sort of terms for goods or services you must use the Accrual method. It is also better as if you ever wanted to change methods as your business grows you would need to ask the IRS for permission. So basically, use Accrual unless you have a Lemonade Stand. :)
Fine, I’ll use Accrual - what’s so great about it anyway??
Well let me tell you :)
Since you record Revenue & Expenses when they happen you have a better indication of how your business actually runs, especially if you have seasonal peaks (rather than when people get around to paying you)
It allows for a longer term view and to be able to compare time periods accurately
It allows for better tracking of Accounts Receivables, what invoices are outstanding, and Accounts Payable, what bills are due
You can expense large purchases that cover a period of time instead of having a large expense one month (i.e. Insurance or Dues)
If you ever grow to $25M in Revenue or wish to go for Investment or Financing the Accrual Method is the acceptable standard
There must be a downside, so what doesn’t it do?
It is slightly more work to do, you may pay taxes on any Revenue you Invoiced, but have not yet received payment for, and you need to track your Cash Flow separately (i.e. your checkbook).
However, all of these are easily dealt with if you have the right software and accountant in place.
So what’s the bottom line here?
So your main take-a-ways from this are:
Use Accrual Accounting - period end of story
Get the right accounting software for you and your business
Hire the proper professional to assist you
If you have a low volume of activity and feel confident to do the day-to-day yourself (this is where having the right software comes into play, not all packages work for all people and all businesses), hire an outside Accountant to do a Quarterly close and to review your books with you
If you have a higher volume of activity you will probably want someone for the day-to-day transactions and for closing out the Month or Quarter and regular reviews - whether that is a Bookkeeper for the day-to-day and an Accountant for the close and reviews or an Accountant that does both is up to you
Check out our post: Top 5 Attributes You Need to Look For In an Accountant
Hopefully that helps make the muddy water a little clearer. :)
For even more check out our other post: Accounting Terms For Non-Finance People
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