Accounting and bookkeeping can be a slippery slope, especially if you’re not a number nerd. There are taxes and cash flow and budgeting to think about, plus you want to make sure you keep track of your numbers, so there’s enough money to keep the lights on. Let alone simplify what needs to be done at year-end for your CPA.
There are two types of accounting that businesses use to keep their finances on track: cash and accrual accounting. And while I have a preference (continue reading to find out), it’s important to know the difference between the two so you can make the decision about which type to use when setting up your accounting software.
During the initial setup, one of the (many) choices you need to make is whether or not you will choose cash or accrual for your method of accounting. Keep in mind the default is always set to cash. The reason being is it is a standard in the accounting world. Also, keep in mind, in your accounting software, you can toggle the reports to cash or accrual view – depending on how you need to see your numbers. But, remember, you will need to do the bookkeeping in accrual format if you want the accrual reports to look right. Note: you can setup your software to be cash and view all of your reports in accrual. A lot of Number Nerd clients do this.
There are reasons you would choose accrual. If you have a large accounts receivable and your invoices are not paid for 30+ days or more. Accrual would be my choice for you. Now, this particular instance is simple in an accounting program because you would simply toggle your Balance Sheet to accrual for the accounts receivable to show up.
Typically accrual accounting doesn’t come into play until you have been in a business awhile or when your CPA gets involved at tax time and tells you that you should make the switch and why. Unless of course, you know ahead of time (when you initially started your business) you are going to have inventory or have a large account receivable (money people owe you for services). Thus, making it a no brainer to setup your bookkeeping in the accrual method for reporting purposes. The difference is unless you meet the requirements listed in the next sentence you can choose which method you will use. The IRS states that if you are a C corporation or gross more than $5M in annual sales or have an inventory with gross sales over a $1M then you are required to use accrual accounting for tax purposes.
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Accrual Accounting – A Definition
According to Intuit, accrual accounting involves recording income when you complete a service or when goods are shipped and delivered. It recognizes expenses when they’re incurred and revenue when it’s earned, not when the payment is made or received.
For example, someone who sells items on Amazon would record the sale immediately, even though the payment of that sale still takes several days to process (ship out the order). Likewise, a service-based business records a sale immediately, even though invoicing terms might be net 30.
What makes accrual accounting a little hairy is that it records income and expenses at the time of the transaction, rather than when the cash changes hands. It forces business owners to keep track both of the transaction and the bottom line when a transaction is completed. For small business owners, this can get cumbersome and confusing, sometimes resulting in overdrawing an account if you’re not careful. And it does require monthly and year-end journal entries in your accounting software to “accrue” for things. So, keep in mind that this would not be a do-it-yourself accounting solution. You are going to need an expert to help you and it will take more time and expense by a bookkeeper to get this done right.
Cash Accounting – A Definition
According to Intuit, cash accounting is a simple form of accounting with “a primary focus on when cash enters and leaves a company’s bank account.”
For small to midsize businesses, cash accounting is typically the way to go. It’s gives you a better big-picture view of where your finances stand day-to-day. It’s also an easier way to keep an eye on the money coming into and moving out of your account–because you literally don’t have more cash on any given day than what’s in your bank account.
Cash accounting is much more straightforward for the small business owner, and it’s easier to keep your bank account in the black. And it makes sense when you’re dealing with smaller amounts of cash. That $1500 invoice you sent out today may not be paid for another 45 days, regardless of your payment terms. So to count it as income now just doesn’t make sense.
For example, an attorney, business coach, or bookkeeper will record a sale the moment that sale is made regardless, while expenses are also recorded right at the time of purchase.
Which is Better for You
Always talk to your accountant before making a decision about how to handle the accounting in your business. Your accountant will likely have a preference, depending on your business type and size. Keep in mind that accrual accounting will take more time to do the bookkeeping and therefore carry an additional expense with that time.
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In my opinion, cash is always better unless you need to use accrual accounting financial or tax purposes. It gives a truer picture of where you are at financially in your business, and they money you have now, in the bank.
Do you know what your monthly overhead expenses are in your business? Keep track with my Bookkeeping Routine Checklist
