Between managing cash flow, invoices, payroll, and debt obligations, your business finances can feel about as easy as herding cats.
With so much to keep track of, it’s vital to set up a consistent method of accounting to wrangle all of the details. Not only will an accounting system keep those elusive "cats" in order, but that order contributes to making your business more efficient, flexible, and profitable.
There are two types of accounting to choose from: cash basis accounting and accrual basis accounting. Determining which option works best for you will largely depend on your business type and how you prefer to record transactions or expenses.
Read on to learn more about the differences between accrual vs. cash accounting and the main benefits of each.
What Is Accrual Accounting?
This type of financial accounting involves recording income and expenses when transactions take place, even if there’s no immediate exchange of money.
With accrual accounting, the goods or services provided to customers are immediately entered into the books as earned revenue. In this way, the timing of revenue isn’t critically important to accurate accrual accounting.
Likewise, any expenses or pending debt obligations are recorded as they are incurred, not when they are paid. The accuracy of entries is later verified and updated with the double-entry accounting method as customer invoices clear or expenses are paid.
Please note: If your company’s sales revenue exceeds $27 million over a three-year period, the IRS will require you to follow the accrual basis accounting method.
What Is Cash Accounting?
Unlike accrual basis accounting, cash accounting only records income and expenses when money changes hands. This means that cash transactions and credit card payments are entered into the books on the same day they are processed.
Rent, utilities, payroll, and accounts payable are also recorded only when they come due. While less accurate than accrual accounting, cash basis accounting is much easier to navigate and is ideal for smaller businesses with fewer assets to manage.
Key Considerations for Startups
The type of accounting system startups use depends largely on how they operate. The accrual accounting method is ideal for startups aiming to gauge financial performance, attract investors, and comply with regulatory requirements.
If you want your startup to be a publicly traded company, you will be required to follow Generally Accepted Accounting Principles or GAAP. Since only the accrual accounting method is GAAP compliant, you’ll need to use this method for both tax purposes and internal bookkeeping someday. It certainly doesn't hurt to start practicing these habits now, and since investors prefer accrual accounting, you’ll be better prepared to attract their interest.
On the other hand, if your startup has relatively little working capital and no inventory, the cash basis accounting method may be best. This is especially true if you’d like to minimize your tax liability over specific financial periods.
For example, say your business uses the accrual accounting method and reports $20,000 in revenue from unpaid invoices in December of 2023. However, payment for these invoices isn’t received until the first of January.
This can be a problem for your startup if you have sharp profit margins and relatively little cash flow. Your tax liability will increase despite not receiving the income during that tax year. With the cash accounting method, you’ll only pay taxes on the money your business earns as it comes in.
Advantages of the Accrual Method
- Greater Financial Foresight - Since the accrual method recognizes revenue and expenses before receipt or payment, it can give business owners a clearer picture of their company’s financial situation. Accrual accounting is especially well-suited for larger businesses that need a more in-depth financial picture of the company to track multiple income streams or large inventory volumes.
- Eligible for Stock Trading - In addition, since the accrual method follows GAAP accounting standards, utilizing this form of accounting will ensure your company is eligible for public trading from the onset. Another benefit to the accrual method is that it can generate the kind of financial reports that investors like to see, as it provides much more information than the cash method.
- Saves Time and Money Later - If you expect your startup to take off in the coming years, starting with the accrual method upfront will save you an enormous amount of time and resources on switching from cash to accrual accounting in the future.
Advantages of the Cash Method
- User-Friendly - The biggest benefit of using the cash method is its simplicity. Since you only record payments and expenses as the transactions are completed, you won’t need to worry about following the time-consuming double-entry method used in accrual basis accounting. This ultimately makes producing and interpreting financial statements a much less daunting task.
- Fast - With cash accounting, all your expenses and income will be immediately clear at any given moment, allowing you to make decisions quickly with all of the information at hand.
- Better for small businesses - If you’re running a smaller business with fairly consistent sales and expenses, the cash method may be the best option for you. If you intend to keep your business small and privately owned, you won't have to worry about GAAP, so the cash method is an easy choice.
The Importance of Choosing the Right Accounting Method
In short, the cash method is more user-friendly and less labor-intensive, while the accrual method has much higher accuracy but is also more time-consuming.
You’ll want to select an accounting method that compliments the type of business you operate and your organization's goals.
Accurate accounting is the cornerstone of any company’s long-term financial health. By building your company from solid financial ground initially, you can help your organization remain resilient during fluctuating sales or economic uncertainty.
Partner With a Full-Service Finance Firm for Enhanced Results
You started your business because you're passionate about what you offer, not because you love keeping up with a lot of hairy financial details.
If you know you need to get your accounting organized but feel out of your depth, you may consider relying on others with real-world experience to help.
Whatever method of accounting you use, a proven team of seasoned financial professionals can ensure consistent recordkeeping and financial reporting for your company.
The right financial operations firm will empower you to take the reins of your company’s financial future so you can move forward with confidence.