Every business needs a bookkeeping system to track and reflect their income and expenses. The two primary methods of tracking this information are the accrual method and the cash method. The difference between these methods is the specific timing of when sales or purchases are added to the books. Most small business are free to choose which method to use. But, which method is right for your business?
The Cash Method
When using the cash method, a business does not count their income until payment is actually received. Expenses are likewise not counted until the money has actually been paid. None of your bills are accounted for until after you have already paid for them. The method does not allow for a store to bill customers for products at a later date, as there is no system in place to track money due from customers.
This method is the most popular among small businesses because it’s easier to use and is useful for tracking cash flow. Without considering the flow of cash through your business, you can end up without enough cash on hand to cover operating expenses. However, it can be difficult to match specific expenses to the revenue they helped generate using this method.
The Accrual Method
With the accrual method, all transactions are recorded into the books as soon as they occur, whether or not any cash is exchanged between parties. If you were to offer store credit to a customer, you would record the transaction immediately under an “accounts receivable” account.
Likewise, if you were to make a purchase using credit, it would be recorded into an “accounts payable” account. This method does a better job of accurately showing you the income and debt your business incurs. But, it does a poor job of tracking actual cash on hand. If your customers aren’t quick to make their payments, you could end up with little cash, even though you’ve earned revenue.
Choosing a Method
As mentioned, most small business owners choose the cash method of accounting as they are establishing their bookkeeping systems, especially in the case of small businesses with no inventory. But, as their businesses start to grow, they often switch to accrual accounting so that they can track revenue and expenses more accurately.
In the U.S., a business is required to use the accrual method if they have sales of over $5 million, or over $1 million if they have inventory. However, many businesses that use the accrual method also monitor cash flow to make sure the business has enough cash on hand to operate at all times.
Depending on the needs of your business, either of these accounting methods can give you a picture of your finances. However, in order to gather the most information for your books, you can employ elements from both methods. Some business owners keep a cash account separate from their accrual account. This allows them to monitor their cash flow in addition to the long-term financial needs of their business.
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