Have you started a business and are wondering what accounting method (cash or accrual) is best for you to use? Do you find yourself with annual debate if you should switch accounting methods? Or do you have different accounting methods you use for financial reporting vs. tax reporting?
The two main methods of record keeping are either accounting for your income and expenses on a cash basis or on an accrual basis. Each method is uniquely different and each has its pros and cons. You should understand each method in detail before deciding which to use.
The cash method is the most common used accounting method for tax purposes for small businesses with sales of less than $5 million a year. Under this method you record income as your receive money and record expenses when you pay them. The accrual method, on the other hand, accounts for income and expenses when the services are rendered, goods are received and actual sales occur. This is typically the method that bankers, surety bonders and other regulatory agencies look for when requesting financial statements from you.
The cash method provides a better picture of how much actual cash your business has. The accrual method shows the flow of business income and debts more accurately and therefore provides the most accurate picture of the financial state of your business. This method matches the revenue & expense in the same period that they occur. As an example, you may have a stellar month/year of sales but your payment terms may not require payment until a later date. In the cash method you would not show that income until it was actually received at that later date. This would be beneficial for tax purposes to defer the income until you actually receive it, but it you are submitting financial statements to a financial lender it would not provide them useful information to provide you funding as they would see no sales during that period.
When determining which method is best for you, you should consider various factors with one of the most important being who is the intended user of the financial statements and financial data? Or who in the future could be an intended user? When you start your business you may be just tracking items for tax purposes and not thinking of the larger picture of when your business grows. Another important factor is what type of an accounting software package are you using? Does it provide the flexibility to carry out your business and provide both accrual and cash basis reports? A common small business software which provides the users this functionality is QuickBooks.
If you are considering implementing a method in your new business or switching to another method, you should consult your CPA and the intended users of your financial statements to understand what information they need and want. If you are unable to meet with them and want a good starting point, you may want to start using software which will track it both ways for you.