If you were one of those in the full swing of business while the rest of us were firing up the grill this weekend, I want to ask…
How is business going for you? Are you faring the storm of inflation and *possible* recession well?
I’m always ready to hear an update on where things are at in your business … Let me know how things went this weekend or where your business is at in general.
I’d also enjoy hearing if there’s another way my team and I here at Ratio CPA, LLC could serve you and your business. Are there any decisions looming that we could help provide insight into?
We’re here for more than just “books” and taxes:
But speaking of those books, let’s continue our series on business finance basics with a dive into the two basic accounting methods so you can determine (or adjust into?) the right method for your business.
An Accounting Methods Rundown for Businesses
“Accounting is the language of business.” – Warren Buffett
How you keep your books is one of the most important decisions you’ll ever make about your business, and there are two methods to do it. Each comes with entirely different requirements and benefits.
So… cash method or accrual method: Which of these accounting methods is right for your company?
In the hand or in the future
Fundamentally, the difference between cash and accrual methods of accounting is in the timing of the recognition of revenue and expenses. The cash method immediately recognizes them. The accrual method recognizes anticipated revenue and expenses.
As a practical example, let’s say you’re declaring that you’ve got a hundred dollars. With the cash method, this means somebody just gave you five twenties. With the accrual method, it means somebody has promised to give you five twenties.
Accrual accounting generally provides a more accurate view of how a company is doing over time; it’s the method more commonly used by large companies and those that are publicly traded. The cash method, on the other hand, is often used by sole proprietors and smaller businesses.
Both have advantages and disadvantages.
Pros and cons of accrual accounting
The accrual method records accounts receivables and payables (A/R and A/P) and can give you – and others interested in your company – a long-term picture of how your company is doing. This is especially true if your business often has less-frequent but large influxes of revenue.
Time balances out the revenue and the expenses in a way that paints a clearer picture of how the company is doing overall than the cash method would. Over time, insights gleaned from the accrual method help can you make better strategic decisions about your business.
Investors (and lenders) also like accrual accounting: The method is usually for companies that file audited financial statements and is used under generally accepted accounting principles or GAAP (more on this in a future article).
Accrual does not track cash flow, though, meaning that a major immediate cash shortage might not stand out in your books. Accrual is also generally more complicated to use since it might account for such things as unearned revenue and prepaid expenses. That complexity can mean you need more in-house personnel or pay more for outsourced services (though a lot of standard business software can help with accrual accounting).
To handle day-to-day and month-to-month regular expenses, you account for cash separately under this method. In an accrual system, you can also sometimes record income in a tax-advantaged way. (We’re happy to tell you more about this).
Pros and cons of cash accounting
Cash accounting (as you can guess from the name) puts cash flow front and center and is much simpler to use than accrual – you don’t record A/R or A/P, for instance. The cash method is so simple it’s been compared with systems used to track personal finances.
But in a sense, cash accounting shows the results of work done in previous periods, potentially giving you a false sense of your company’s profitability. In other words, you might have cash on hand just because you haven’t paid a bill yet. Simplicity has its drawbacks, too: No full record of A/R or A/P can create problems if your company isn’t paid timely or has an unusual number of outstanding bills.
And again, you have no GAAP if your company grows. According to GAAP, you must use accrual if you exceed 25 million dollars in annual revenue (though you can use it, under the Tax Cuts and Jobs Act of 2017, if your business makes less.)
Some businesses employ hybrid methods, using accrual accounting to make strategic decisions and apply for loans and cash accounting to simplify taxes. A lot of software claims to be able to handle this, too, but hybrid accounting is tricky and restricted in terms of which businesses can use it. Check with us on this.
Which is better for you?
Accrual accounting is by far more popular for most businesses for its holistic view, scalability, and usefulness in making long-term decisions for a company.
If you’re a small company doing business primarily through cash transactions and you don’t have to keep a large inventory, cash accounting can be convenient and effective.
The obvious first questions to ask yourself are: How complex is your business? Do you plan to go public? What are your sales? Are you growing – and how fast?
Your accounting method is a huge deal for your business. Make sure you pick the right one for the right reasons.
Whether your business is just starting out, or you’ve been doing business a while, choosing the right accounting method is pivotal. Let’s take a look at those books and determine where your business accounting should land:
Or just reach out if you have follow-up questions and need some advice. I’m on your team.
In your corner,
Ratio CPA, LLC