Cash or Accrual Accounting Method
Introduction
For businesses, their accounting method is an important component in measuring their financial health and performance. Types of businesses can use two major accounting methods: the cash basis and accrual basis. The cash basis of accounting records revenues when cash is received, and expenses when cash is paid. The accrual basis of accounting records revenues when earned and expenses when incurred, regardless of when cash is received or paid. Knowing which method is best for you and your business is important in order to understand what affects your company’s financial statements.
Advantages of Cash Accounting
Cash accounting records sales when the cash is received and expenses when the cash is paid. This method is simpler and more straightforward, requiring fewer calculations and a more manageable accounting system. Cash-basis accounting is useful for small, service-based businesses that may not have inventory to track. Taxpayers who use the cash basis of accounting are allowed an immediate deduction until the cash is received or expenses are paid.
Advantages of Accrual Accounting
Accrual accounting records revenues when they are earned and expenses when they are incurred, regardless of when the cash is received or paid. This method provides a more accurate picture of a company’s financial position since it recognizes revenues and expenses more quickly. Also, the use of the accrual basis allows for more efficient monitoring of the status of a company’s accounts receivable and accounts payable.
Income tax planning may also be easier to plan with the use of the accrual basis because you can choose when you want to claim certain expenses or generate certain incomes. That way, certain expenses can be matched with certain incomes in order to minimize your tax burden.
Disadvantages of Cash Accounting
Cash-basis accounting may not provide an accurate picture of a company’s financial standing because it will only record sales or expenses when cash exchange takes place. The cash basis of accounting also delays income recognition and defers expense recognition, which can affect any performance or valuation measures. In addition, cash basis taxpayers are required to report more income on their tax returns than those taxpayers who use the accrual basis of accounting.
Disadvantages of Accrual Accounting
Accrual accounting requires more complex calculations, and the tracking of more information, than the cash basis accounting method. Keeping up and managing the records for the accrual basis of accounting may also be more complicated than for cash basis taxpayers, due to the need for tracking accounts receivable and accounts payable.
Conclusion
Choosing between the cash and accrual accounting methods will depend on your business, its size and its goals. Both accounting approaches provide financial information, but provide different visuals of the financial health of the company. Both methods can be beneficial or can present their own particular challenges and risks, so it’s important to understand and analyze which method would be best for your business.
Knowing and using the correct accounting method will ensure accuracy and reliability in your businesss financial documents. It is important to determine which method is best for your business before you start using it, so that you can be prepared and set up your business to benefit from the advantages of the method you choose, while doing your best to avoid or at least minimize any of the potential risks associated with that method.
