When it comes to accounting for your small business, one of the most important decisions you'll make is whether to use accrual accounting or cash basis accounting.
Accrual accounting recognizes revenue and expenses when they are earned or incurred, regardless of when cash is exchanged. Cash basis accounting, on the other hand, recognizes revenue and expenses only when cash is exchanged. So how do you choose which method to use? In this guide, we'll walk you through the pros and cons of each method so you can make an informed decision for your business.
Section 1: Understanding Accrual Accounting
Accrual accounting is the method used by all larger companies and is required for tax reporting when sales exceed $5 million. The method recognizes revenue and expenses when they are earned or incurred, regardless of when cash is exchanged. The main advantage of this method is that it provides a more accurate picture of a company's financial health since it matches revenues and expenses in the same reporting period. However, it does not reveal the ability of a business to generate cash, unless a statement of cash flows is included in the financial statements.
Section 2: Understanding Cash Basis
Accounting Cash basis accounting is available for use if your business generates under $5 million in sales per year. It is easiest to account for transactions using the cash basis since no complex accounting transactions such as accruals and deferrals are needed. The main advantage of this method is its ease of use, but the relatively random timing of receiving cash and expenditures means that results reported can bounce between unusually high and low profits. This method is also commonly used by individuals when tracking personal finances.
Section 3: Which Method Should You Use?
When choosing between accrual accounting and cash basis accounting, you should consider the size of your business, your tax obligations, and your reporting requirements. If you are a small business generating less than $5 million in sales per year, cash basis accounting may be the easiest method for you to use. However, if you are a larger business or have more complex financial reporting requirements, accrual accounting may be the better choice for you. It's important to consult with an accountant or financial advisor to help you make the best decision for your business.
Conclusion
Choosing between accrual accounting and cash basis accounting can be a difficult decision for small business owners. While the cash basis is easier to use, the accrual basis provides a more accurate picture of your business's financial health. Ultimately, the decision should be based on the size and complexity of your business, your tax obligations, and your reporting requirements. By understanding the pros and cons of each method, you can make an informed decision for your business.
