Understanding the Different Types of Accounting Methods
Accounting methods are the rules that entrepreneurs and companies use to keep financial records and record transactions. As a business owner it is critical to understand your finances and track your income and expenses.
It is therefore important to understand the different types of accounting methods and how you can use them to benefit your business. There are two major methods of accounting. Cash-based and accrual-based accounting.
Each of these methods has different tax implications, so it is important to be consistent in the method you choose. All accounting methods must reflect accurate income to allow you to gauge your success.
Cash-Based Accounting
As its name suggests, cash basis accounting focuses on transactions involving cash. Revenue is recognized only when payment is received, and expenses recorded when cash is paid out to suppliers.
This accounting method is relatively easy and is commonly used by small businesses and sole proprietorship for bookkeeping. Cash-based accounting does not conform to The Generally Accepted Accounting Principles.
Although this accounting method can also be used to manage personal finances, the IRS requires businesses that realize over $5 million in sales to use accrual-based accounting. Cash based accounting is also not a reliable method to determine a businesses’ financial health.
If you are considering buying a small business that uses cash-based bookkeeping, you may not be able to determine unpaid expenses, outstanding receivables, or cash receipts as these transactions are only recorded once cash changes hands.
Example:
A small business selling mattresses worth $300 sells two mattresses to a client on the 10th of September. However, the buyer makes payment on the 30th of September. This sale will be recorded as a cash transaction on the 30th of September when the cash is received.
If the business purchases two mattresses from their supplier on the 5th of September but makes payment on the 10th of September, this will be recorded as an expense on the 10th of September.
Pros:
There are numerous benefits of using cash-based accounting for small enterprises.
- It is a simple accounting method that does not require any specialized skills. This allows business owners to save money on hiring an accountant.
- You do not require any specialized accounting software. An inexpensive cash book and spreadsheets are enough to keep your records updated.
- Cash based accounting gives an accurate representation of cash inflow and outflow allowing you to get the true picture of how much cash your business has at any given time.
Cons
- Sophisticated accounting software often comes with built-in error detection mechanisms. Businesses using cash-based accounting do not have the benefit of these systems increasing the risk of errors.
- Cash basis accounting cannot give you an accurate representation of your business’ financial position because there is no way to generate income statements or balance sheets.
Accrual Based Accounting
This accounting method records transactions when they are initiated. Accrual based accounting records revenue when it is earned and expenses when they are incurred irrespective of when cash was exchanged.
Businesses using this method rely on advanced accounting and use current assets, accounts payables, inventory, as well as long-term liabilities to determine their true financial position. The IRS requires all businesses using accrual-based accounting to report their income on a yearly basis.
Example:
A small business selling mattresses worth $300 sells two mattresses to a client on the 5th of September. However, the buyer makes payment on the 30th of September. This transaction will be recorded on the 5th of September, irrespective of when payment was made.
If the business purchases two mattresses from their supplier on the 5th of September, but makes payment on the 30th of September, the transaction is recorded as an expense on the 5th of September, when the transaction was initiated.
Pros
Accrual based accounting offers numerous benefits to larger businesses and companies.
- If your business sells on credit, you can record the transactions and invoices to track your income.
- It is easy to track how much your business owes suppliers and vendors as all transactions are recorded when they are initiated.
- If buying or selling a business, it is easier to determine its financial position.
- You can generate financial reports that make it easy to secure funding.
Cons
- It is more difficult to determine cash flow because transactions are recorded when they are initiated even if payment has not been made. This makes it difficult to determine exactly how much cash you have in the business.
- This method is more complicated as it relies on the double-entry method. Business owners must have specialized knowledge or hire accountants for bookkeeping.
- Businesses incur extra costs when buying accounting software. Each transaction is recorded under two accounts which make businesses reliant on accounting software to track transactions and detect errors.
How to Choose a Tax Accounting Method
Choosing the right accounting method for your business is critical as it can have a significant impact on your records and affect your taxes. As a business owner, opt for a method that suits your needs as each of these methods recognize revenue generated differently.
Cash-based accounting is best for businesses that do not sell on credit while accrual basis works best for businesses that extend credit to many customers. If your business has fewer transactions and does not have physical assets that need inventory tracking, cash-based accounting is best for you.
Opt for accrual-based accounting if your business has many financial transactions on a daily basis as you can use modern software to track these transactions with no risk of errors. Lastly, consider the method that works best for you during tax season, as both methods report income differently.
Get in touch with us to learn more about cash basis and accrual-based accounting methods and which one is best for your business.
