The world of financial accounting is foreign to many business owners. And if we’re being honest, it’s sometimes the last thing that any company leader wants to deal with.
However, possessing a basic understanding of bookkeeping fundamentals is critical to keep your business afloat.
Is the word “accounting” enough to make you want to close the computer? Fear not. We’re here to make it digestible.
Let’s take a look at the two different kinds of accounting methods your business might use, and the pros and cons of each.
Accrual v. Cash Basis Accounting: What’s the Difference, and Does it Matter?
First things first, there is a world in which you can only use the accrual method of accounting. If your business is making more than $25 million a year, then you’ll have to skip straight to that section of this post. (Unless you’re just interested in learning the difference, in which case, we commend you!)
For everyone else, you can choose between these two distinctive methods. But what’s the difference, anyway?
When you follow the cash basis accounting method, you record your income or expenses the moment the money exchanges hands. When you choose the accrual method, you’ll record transactions as they occur, regardless of whether the payment has actually been made or received.
Take the following as an example:
You pay $12 for an annual subscription to a magazine on January 1st, which equals $1 a month. With cash accounting, you’d record the $12 expense in January, since that is the amount of cash that left your bank account at that time.
But with accrual accounting, you would record $1 for every month of the year.
Got it? Great! Let’s delve in a little deeper.
Cash Basis Accounting
There’s no denying it: cash accounting is definitely the simpler of the two. With this method, you’ll record revenue and expenses as soon as the cash flows in or flows out. This can be a perk for small business owners who don’t want to be bogged down by complicated bookkeeping procedures.
But there is one big disadvantage to cash accounting. This method doesn’t provide a very accurate depiction of your business’s financial health, simply because it doesn’t account for money that you owe or money that is owed to you. So while it might seem like a load off your back while you’re busy conducting the day-to-day operations of your business, it can leave you blinded to the reality of your financial situation.
The accrual method records revenue and expenses over time, as they occur. So for businesses looking to gain a more accurate picture of their financial health, this is the best route to take.
When you use the accrual method, you’ll get a very clear picture of when business will be booming, and when there’s a lag in sales. Not only does that help you develop a proactive sound plan of action for monitoring cash flow, but it also ripples out to the decision-makers in a variety of different departments. For example, when you can predict the slower months ahead, you can get sales and marketing firing on all cylinders to develop income-generating strategies and cost-cutting plans.
The main disadvantage of the accrual method is how complex it can be to monitor and understand… Especially if finance isn’t your first language.
So Which Accounting Method Should I Use?
At the end of the day, we always recommend the accrual method for business owners who are serious about taking control of their company’s financial health.
If you need help understanding what the numbers are telling you, hire an expert today to help manage your books.