Know the Difference Between Cash and Accrual

Every business has to keep track of money flow, but there's more than one way to do it. Review the basics before you decide what is appropriate for your business.

Cash method of accounting
In this system, you record income as it's received and expenses as they're paid. You don't make a note of any invoices or bills you send, but instead record income when you actually have the money in hand. If your business makes less than $25 million in sales a year and doesn't sell merchandise directly to consumers, cash accounting might be the best choice for you. It's a simple system, similar to how you might track your personal finances.

If your business doesn't maintain large inventories, cash accounting is convenient and reliable, allowing management to keep tabs on revenue and expenses without a great deal of bookkeeping. You don't have to pay income tax on any money that hasn't been received yet, helping improve cash flow and ensuring that your business has funds available for tax payments. If you're a sole proprietorship or a very small business, this keeps your business afloat when cash flow is restricted.

Of course, there are disadvantages. It's hard to tell whether high cash flow in a particular month is a result of work done in that month or you're receiving delayed revenue from a previous month. And there are no records of accounts receivable or accounts payable, creating difficulties when you don't receive immediate payment or have outstanding bills.

Also, it doesn't conform to generally accepted accounting principles, the standard framework that accountants must adhere to when preparing financial statements. If your business really takes off, you'll have to update your accounting practices. If you think you could get larger, then you should consider the accrual method.

Accrual method of accounting
This system provides a clearer picture of a company's overall finances. The business records income when it is earned and expenses when they are billed, no matter when the money is received. This gives business owners a longer-term view of how the company is faring, showing how much money it's earned and spent in a specific time and providing a clearer gauge of when business speeds up or slows down.

Even though it requires more intensive bookkeeping, accrual accounting gives owners a more realistic idea of income and expenses over a specific time, providing a better understanding of consumer spending habits and allowing you to better plan for peak months. Its complexity may mean you need some bookkeeping help, either in-house or outsourced.

Also, the system may give an inaccurate picture of your short-term financial situation. You'll have to track cash flow separately to make sure you can cover bills month to month because accrual accounts for money that hasn't come in yet. Indeed, you need very careful bookkeeping practices; your books could show a large amount of revenue when your bank account is empty.
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Which method you choose is ultimately a management decision, depending on your business goals, the resources you have available, and your firm's size and financial requirements. It's wise to speak with an accountant and tax professional in your decision-making process.