Accounting Basics: Cash or Accrual for Your Small Business.
(ThyBlackMan.com) Accounting is the language of business, so when you’re looking to pursue a career in the business field, what’s more essential to learn than accounting basics? There are, of course, platforms that incorporate a basic accounting system for small businesses, such as Shopify, but assuming you didn’t have that luxury–what would you do?
Decide Which System to Use
According to Enterpreneur.com, most small businesses resort to two main accounting systems: cash based and accrual based. How can you decide on which system to use for your small business? Well, this all depends on the sales volume and your business structure. While the cash based accounting system is simpler than the accrual system, the system technically only records the inflow and outflow of your cash in the books. The cash system can prove to be effective mostly for sole proprietors and businesses that don’t have high levels of inventory on credit.
This is not to say that you cannot start off with a cash based system and transition to accrual. In fact, a lot of small businesses do in fact start off using a cash based accounting system. When thinking about the tax benefits, using a cash based accounting system can help you report expenses right away but put off reporting the income until the next taxation year. The key disadvantage to using the cash based accounting system is exactly why you would begin using it in the first place. It is too simple to acknowledge credit sales and anything beyond cash. As a growing business, this will make it difficult to track your actual revenue and measure progress.
Advantages and Disadvantages
There is no timing advantage when it comes to using the more complex accrual accounting system. Your earnings and expenses are recorded as they occur throughout the taxation year. This includes both cash and credit transactions. Invoices are created for each transaction and recorded in the books as they are issued to the correct stakeholders. Similarly, your employees must log all information regarding credit sales. Why is it such a huge disadvantage? Because credit sales may not come in time and you will have no choice but to report income that you have yet to actually receive.
Now this begs the question: is cash based accounting better or is accrual based accounting better? The same answer will come up: it depends. But for a very fair reason, there are also defined guidelines set out for taxation. For those businesses that exceed $5 million in income during the taxation year, accrual based accounting is required. Service-based small business may have an easier time keeping away from accrual based accounting for longer, but this also cannot be avoided for small businesses that keep reasonable levels of inventory.
That being said, both accounting systems are misleading in their own ways. Cash accounting can show a client to be a loss because of the reported expenses and unreported income on credit. At the same time, accrual accounting could show a client to be more profitable than they really are with the pre-reported revenue. On both ends, this plays into how decision makers interpret the information. The danger is in incorrectly interpreting the numbers in your books.
Using Both at One Time
Still can’t decide on which accounting system to use for your small business? Fret no more, you can use both! Yes, there is a possibly for you to use both systems. Use accrual for managerial accounting decisions and the cash system for the purposes of reporting your revenue in the coming taxation year. This way, you won’t have to stress over getting taxed for revenue on credit that you have yet to receive.
Want to hire an accountant? There are a few things you should be aware of when consulting an accounting professional before making any detailed decisions regarding your small business accounting. Keep in mind that having a good understanding of the industry can certainly change a lot of your decision making. The bookkeeper or accountant you end up hiring may have no clue as to how your business should be operating. Trust that you are miles ahead when it comes to knowledge and experience in your field of expertise and don’t just take anyone for their word without looking for answers yourself.
What do experts from accounting firms say? They say to keep with accrual based accounting as a small business. This way, if your business grows, you won’t incur any transitional costs to start working under a new system. The typical standard is, if you as the owner can keep tabs on every job, employee and product, then there is absolutely no harm in using cash accounting. If your answer is otherwise, chances are your small business is growing beyond a scope of which you can completely overlook on your own.
Staff Writer; Greg Slade