Every business needs a way to track its income and expenses. This is where accounting systems come in, with two main options: cash basis and accrual basis. Understanding the difference between these two will help you pick the right system for your business.
Cash Basis Accounting
Think of cash basis accounting as tracking money in and out of your business like a checkbook. You record income only when you receive payment, and expenses only when you pay them.
- Pros: Simpler to understand and manage, especially for small businesses. Gives a clear picture of your current cash flow.
- Cons: Doesn’t reflect the actual timing of when income is earned or expenses are incurred. Can lead to inaccurate profit and loss statements.
Example: You run a dog walking service. In January, you complete 30 walks for a total of $300. However, clients only pay you in cash at the end of each walk. Using cash basis, you wouldn’t record this income until February when you receive the payments.
Accrual Accounting
Accrual accounting provides a more complete picture of your business’s financial health. You record income when it’s earned, regardless of when you receive payment, and expenses when they’re incurred, regardless of when you pay them. This requires keeping track of outstanding invoices and bills.
- Pros: Provides a more accurate picture of your business’s profitability. Helps with budgeting and forecasting future income and expenses. Required for larger businesses and corporations.
- Cons: More complex to manage than cash basis. Requires keeping track of accounts receivable (money owed to you) and accounts payable (money you owe).
Example: Continuing the dog walking service example, under accrual accounting, you would record the $300 income for the 30 walks in January, even though you haven’t received payment yet. You would also record any expenses incurred in January, like dog treats or poop bags, regardless of when you pay for them.
Choosing the Right System
Here are some factors to consider when choosing between cash and accrual accounting:
- Business Size and Complexity: Cash basis is generally easier for smaller businesses with simple transactions. Accrual is better for larger businesses with inventory or complex sales cycles.
- Tax Implications: Consult your accountant to see if cash basis is acceptable for your tax filings.
- Your Needs: Consider which system provides a clearer picture of your business’s financial health for informed decision-making.