Are you starting a small business and unsure of how to handle your bookkeeping and accounting records?
This is definitely a common challenge for many small business owners yet it is a vital aspect of running a business.
One question you might have about this subject is whether you should use the cash basis vs accrual basis for your records.
What’s the difference with these methods? Is one better than the other? Is one easier than the other?
If these are questions you have, let me explain everything you need to know about both the cash basis of accounting and the accrual basis.
The Cash Basis of Accounting
The cash basis of accounting is a very simple method of recording your business income and expenses, and it can easily be compared to the way you manage your personal finances.
The basis of this method is that you only make accounting records to your books when money is exchanged, and there are basically two ways money is exchanged:
- When you pay for something
- When you get paid for revenue from your business
With the cash basis, you make an entry only when you actually receive money from a customer or client or when you pay money out for a bill or expense of some kind.
Examples of the Cash Basis
To better understand, let me give you a few examples of how the cost basis of accounting works.
Example 1:
You receive your electric bill for your business on the 1st of the month and it’s due on the 17th in the amount of $225. If you write a check to pay for this bill on the 15th, you record the expense on the 15th because that’s the day you paid it.
Example 2:
A customer calls you for work on the 1st of the month. You go to the customer’s house and provide all the work he or she needs on the 10th of the month. You send a bill on the 30th of the month for services totaling $475.
On the 10th of the following month, the customer pays you for the work in the amount of $475. On this date, you record the money as income on your books.
The Accrual Basis of Accounting
The accrual basis of accounting is very different than this.
In fact, this method does not base recording transactions on when money is spent or received. Instead, the basis is that you record the transactions on the dates they occurred.
You make an accounting record of a transaction on the date in happens, regardless of whether you received or paid out any money. The exchange of money is irrelevant with this method.
Examples of the Accrual Basis
To understand this method, let’s use the same examples from above to see how you would record the transactions using the accrual method.
Example 1:
From the electric bill example from above, you would record the transaction on the date you received the bill. So on the 1st of the month when you received the bill, you would post this as an expense for utilities.
You would also include an entry to accounts payable to record this bill that you must pay when it is due.
Example 2:
To record the income example from above with the accrual system, you would post the income as revenue on the 10th of the month – the day you provided and earned the income.
You would also post a transaction to your accounts receivable account to represent money owed to your company.
Why the Cash Basis Is More Advantageous for Tax Purposes
A lot of small businesses prefer the cash basis because it is easier to use but many also prefer it for the tax advantage it can offer.
The cash basis gives you more control over when you post entries which means you can record them in a way that best suits your profits and losses.
If, for example, you want to reduce your net profit for tax purposes, you could quickly pay all your debts and bills right at the end of the year. By doing, you can reduce your net income by increasing your expenses, resulting in lower taxes.
You could also wait to post money received for income until just after the first of the next year. If you do this, the money would post as income for the next year and not the current tax year.
You can use the freedom of when you post expenses or income to your benefit. You do not have this type of control with the accrual method of accounting.
Which Method Should You Use? The Cash Basis vs Accrual Basis
There are advantages and disadvantages of both types of systems and you should carefully consider which is best for your business. Whichever you choose will be the one you have to stick with unless you get approval to switch.
If you’re not sure is right for you, ask an expert who specializes in small business solutions. You could also talk to other small business owners to find out what they prefer.
The one benefit you can reap by choosing the accrual method is the ability to track your company’s performance on a monthly basis.
When you record all the money you earned for a month and all the expenses you incurred for that month, it’s pretty easy to see your bottom line for the month.
You can then view monthly statements of your income and expenses and have a way to compare these apples to apples.
Need Help with Your New Business? Where You Can Turn for Help
You’ll have to choose between the cash basis vs accrual basis of accounting but you can’t really go wrong with either. They’re both great choices.
Do you need setting up your new business? Do you have questions? If so, we can help. Contact us to learn more about the services we offer for small business owners.