Cash versus Accrual Accounting. The Difference Could Kill Your Business.
Accrual-Basis Accounting Method
Small business owners should abide by the generally accepted accounting principles (GAAP — more on that below). One of the most critical components of GAAP is the accrual-basis accounting method, which states that companies should recognize revenues and expenses at the time of a sale. This is different from the cash basis method, which says that you should realize sales when you receive payment.
The accrual basis accounting method is efficient and provides you with a better indicator of your financial position, as it shows the present value of sales revenue. It also requires the double-entry method of accounting. When you enter an accrued transaction, you enter a matching transaction in a different account.
So, let’s say that you sell $10,000 in raw materials and that the buyer agrees to pay $2,500 for four months. These sales take place in November. Under the cash basis method, you would need to create a journal entry each time you receive payment, which means your financial reporting will take place throughout two accounting periods — the end of year one and the beginning of year two. Under the accrual bookkeeping system, you’d log the sales in your receivables account and debit inventory.
Cash-basis accounting is a straightforward accounting method. Under the cash-basis accounting system, you record payments when they’re received or processed. Accounts receivable do not come into play under the cash-basis system.
For instance, let’s say you perform work for a client on March 1 and submit an invoice due in 45 days. The client pays the balance in full on April 15. Under cash-basis accounting, you’ll record the income in April since this is when you received the cash in hand.
If you don’t maintain inventory, you may find cash-basis accounting more useful than accrual-basis accounting. It could also be particularly helpful for service-based businesses. However, it does not meet GAAP standards, which can be problematic if your business grows. Certified public accountants may recommend that you don’t use cash-basis accounting for this reason.