March 8, 2022
Business accounting is an important skill to master whether you are just starting out as a small business owner or looking to expand your entrepreneurial project. Having an accurate view of your financial status at any given time is crucial to know how much money you have at your disposal and how healthy your business is.
There are two methods of accounting that businesses can use: cash basis or accrual basis. Although they sound complicated, understanding the differences between the two and when to use them is very simple.
What Is Cash Basis Accounting?
Cash basis accounting is very simple: you record income once the money hits your bank account and expenses when you actually pay them. For example, if you earned $2,000 from customers in your store on one day and paid out payroll on the same day, you would record both that income and those expenses.
Cash basis accounting does not take into account income or expenses that you predict but have not actually paid or received yet. Continuing with the previous example, if you received an online order for $200 in addition to the $2,000 in cash, you would not count those $200 until the money was deposited into your bank account.
This form of accounting is very simple because you only deal with concrete aspects of your finances that you can prove with receipts and invoices. However, it does not give you as clear of a picture of your financial future as you are not accounting for incoming invoices and bills.
What Is Accrual Basis Accounting?
If you choose accrual-basis accounting, then you record payments and expenses as soon as you become aware of them. For example, if you invoice a client for $200, you record that invoice in your accounting system as soon as you send it instead of waiting for the client to payout. You also record bills as soon as you receive them, not when you pay them.
This type of accounting is helpful when it comes to predicting your future financial health. You have a clear idea of what expenses you can expect for the next period as well as the income that you have to pay for them. It also makes it easier to keep track of unpaid invoices. However, it is a bit more complicated.
Which Accounting Method is Right for You?
Now that you know about the two types of business accounting available, how do you decide which one is best for your business?
One thing to consider is the capabilities that you have to manage accounting. Cash basis accounting is much easier than accrual basis accounting because you are recording concrete payments and expenses as opposed to predicting the future. If you’re the one doing your books after a long day at work, cash is going to be easier, while a team of accountants can handle accrual basis accounting.
The two methods of accounting also have different tax benefits. Cash basis accounting makes tax payments easier because you only pay taxes on what you have already earned and on the money that is safely sitting in your bank account. Smaller businesses are advised to stick to this accounting method to avoid getting walloped with a tax bill for the income they haven’t actually earned yet.
However, you may be required to use accrual-basis accounting depending on the size of your business. The IRS requires businesses with a revenue of over $25 million to use this accounting method, so if you predict earning this much soon, it is better to make the switch now.
No matter which accounting method you use, hiring a reputable accountant can make filing taxes easier.
If you need help with your bookkeeping and accounting, don’t hesitate to schedule a consultation with us!
Even though we are based in Albany, NY, we offer our expertise in business accounting, bookkeeping, and tax preparation all across the United States.