It is important for every business owner to accurately record all transactions. Moreover, bookkeeping for service business is beyond just recording transactions. Accounting enables business owners to plan, set a budget, make fundamental financial decisions, and evaluate the overall performance of the business.
In short, accounting provides an overview of your company’s assets and liabilities. Cash accounting and accrual accounting are types of accounting systems to record transactions. The key differentiator between cash accounting and accrual accounting is the time when these transactions are recorded.
But how do you decide which accounting method is best for you? Let’s begin with knowing more about each accounting system in detail:
Accrual System of Accounting
In the accrual system of accounting, one records revenue when an invoice is drawn up and expenses are recorded when you’re charged bills. Regardless of when you receive income, you’ll record transactions.
For example, if you made a transaction of $100 on March 5 but receive the actual income on April 15, you would still record the income in March.
Accounts receivable and accounts payable are the recording entries used in the accrual method. Accounts receivable is when a customer owes money to you, whereas accounts payable is when you owe money to other parties such as suppliers, vendors etc.
Cash System of Accounting
In the cash system of accounting, you’ll record revenue when you receive income and record expenses when you pay for it. This method is widely used by small businesses and by individuals who manage their own finances.
Advantages of Accrual Accounting
Realistic Financial Picture
Accrual accounting gives a realistic picture of your income and expenses of a particular period. You get a long-term vision of the profitability of your company. A detailed cash flow report can help you make projections, make arrangements for dry spells, and follow up with customers for payments.
Once you grow, you might have to change to accrual accounting from cash accounting. Generally Accepted Accounting Principles (GAAP) mandates that all businesses earning more than $25 million in annual sales must use accrual accounting.
You don’t have to go through the hassle of making the switch when your business grows.
Disadvantages of Accrual Accounting
No Awareness of Cash Flow
Accrual accounting method doesn’t keep a track of cash flow. Though the company looks profitable in the long term, in reality, there is a shortage of funds in the bank. It can lead to poor estimations and decisions because of an inaccurate sense of financial security.
In accrual accounting, a lot of paperwork is involved, making it quite time consuming and tedious. It is also more complex in nature as you have to record transactions like prepaid expenses and unearned revenue.
Advantages of Cash Accounting
The cash accounting system is straightforward and easy to maintain. You have to record your income as and when transactions take place and it isn’t necessary to track your account’s receivables and payables. It is a very convenient method that helps you monitor your revenue and expenses without the need for advanced bookkeeping software or hiring an accountant.
In cash accounting, you’ll pay taxes only on the income received for a particular month. This improves your cash flow as you don’t have to pay tax for late payments. Cash accounting is beneficial for small businesses where cash flow is limited.
Disadvantages of Cash Accounting
No Complete Picture of Financial Status
With cash accounting, you don’t have a clear idea of your account’s payables and receivables. This means you don't know how much you owe to people and how much you’ll receive.
Inability to Take Long-term Decisions
Since you don’t have the complete picture of your company’s financial status, it is difficult to make long-term decisions without knowing how much customer debts affect your company’s profits.
Both accrual and cash accounting methods have their pros and cons. Cash accounting is the best option for small businesses in that have limited cash flow and what a clear and easy to understand picture of their cash flow.
Meanwhile if you’re already making $25 million annually, you’ll have to go with the accrual accounting method as it adheres to GAAP rules and it is the best method that allows for high level financial reporting.
If you are having a tough time deciding which accounting method to choose do not hesitate and contact us, we will guide you, for free!