We know how challenging it can be to always keep an eye on your business expenses. This is why we've compiled a short guide to the two primary accounting methods for keeping on top of expenses: cash basis accounting and accrual basis accounting. Unless you are an accounting professional, it can be difficult to understand the difference between cash basis accounting vs. accrual basis accounting.
1: Cash basis accounting
The cash basis method identifies incoming and outgoing cash flows when the money actually changes hands. This means that invoices are not counted as income and bills are not counted as expenses until their respective payments are processed. This method is simply to maintain, but it cannot be completely accurate as it could indicate that you’re in good financial health despite having large bills to be charged. On the other hand, cash basis accounting does provide you with a more useful overview of cash flow and the amount of cash that’s available to you at any one time.
2: Accrual basis accounting
The accrual method acknowledges invoices and bills as income and expenses as soon as they are received, even if it takes a month for the money to be received or sent. This means it can provide you with a more accurate view of your business’s finances and thereby enable you to make better decisions as a (small) business owner. However, this requires you to be proactive about recording invoices and it also does not give a great insight into the companies cash flow. The business might appear eg more profitable when actually the revenue has not made it into your bank account.
Cash basis accounting vs accrual basis accounting - which one should I use?
Timing is the dividing factor between cash basis accounting and accrual accounting. There is a number of things to consider when deciding which method you use to keep an eye on your company's expenses and company's cash flow. If you want to get the most accurate picture of your business's financial health, being able to register income when the invoice is raised rather than once its being paid is a powerful advantage. However, if looking at the tax advantages of accrual vs cash basis accounting, there are tax benefits to the latter. Say you sent an invoice in 2020 but don’t get paid until 2021, then the tax won’t need to be paid until the following year. This can really help small businesses with limited cash flow. Also, in the US, accrual basis accounting is mandatory for companies generating over USD 25 million in annual sales. This is, of course, only relevant if you make sales or are based in the US.
Ultimately, whichever accounting method you choose should fit your company's goals and financial requirements. While accrual basis accounting is likely to provide you with a better picture of your business’s financial health, and while it’s more complicated to implement than cash basis accounting, the additional insight it provides is worth the additional effort. On the other hand, for smaller companies, cash basis accounting can be the better option due to its better insight into cash flow.