Accounting Methods

The accounting method you choose for your business can impact the accuracy of your bookkeeping and the overall overview of your company’s finances. Choosing the right method can help you determine your company’s financial health and can impact how you file taxes and make important decisions. There are two main accounting methods – cash and accrual – that differ in the timing of when income and expenses are recorded. The cash accounting method records revenue and expense when cash actually changes hands. The accrual method uses the matching principle to match revenues with expenses, resulting in more accurate reporting.

The Accrual Method

The accrual method is a form of accounting that recognizes and records income and expenses when they occur, regardless of when cash is exchanged. This method is more accurate than the cash method because it recognizes revenue when earned and expenses when incurred, not when payments are received or made. Investors and lenders also prefer the accrual method because it provides a more accurate picture of the company’s financial health.

With the accrual method, these future liabilities are recorded and monitored in accounts receivable and accounts payable. This helps to keep track of how much money a company is making or spending, which can help identify any potential problems. The accrual method is also a better option for businesses with inventory, as it allows them to record the cost of goods sold in their income statement, which can be helpful when it comes time to calculate inventory taxes.

The Cash Method

The cash method, also called the cash receipts and disbursements method of accounting, focuses on recording transactions based on when money actually moves in and out of your company’s bank accounts. It’s simpler than accrual and often better for small businesses with fewer accounting needs, as it reduces the number of transactions you need to record and can be easier to reconcile at month-end. However, it can give a limited picture of your business’s health and may make tax preparation more complicated because it doesn’t account for accounts receivable or payable. Using the cash basis, you recognize revenue when cash payments are received from customers, and you recognize expenses when you pay cash to vendors.

Since the cash method doesn’t take into account a company’s accounts receivable or payable, it can lead to “lumpy” profitability in any given period because profits could be significantly impacted by a large cash inflow or outflow. Additionally, the IRS limits the amount of revenue that can be recognized using the cash method. Using this method can also be difficult to explain when filing taxes because you must provide detailed information on your tax return about income earned in any period that the company hasn’t actually received the money.

Differences Between The Accrual method and Cash Method

The main difference between accrual and cash methods is the timing of when revenues and expenses are recorded. Companies that use the cash method record revenue when they receive customer payments and expenses when they make payment to vendors. This approach can be simpler for small businesses, and it provides a snapshot of a company’s cash flow. However, the cash method may not provide a complete picture of a company’s finances over time since income and expenses are recorded sporadically rather than consistently.

Another major difference between the two accounting methods is how they impact taxes. In the cash method, a business only pays taxes on the money it actually has in its bank accounts. This can lead to an inaccurate picture of a company’s tax liability, especially if the company is profitable but isn’t yet receiving cash payments from customers. On the other hand, the accrual method allows a business to take advantage of depreciation, which can save money on taxes over the long term.

A third difference between the two accounting methods is how they affect the balance sheet. The cash method only shows a company’s current assets and liabilities, while the accrual method also includes the future value of receivables and payables. This can give a more accurate picture of a company’s financial health and help with long-term planning.

Whichever accounting method you choose, it’s important to record your income and expenses consistently. Make sure to keep track of all your transactions regularly and compare your company’s results over time to spot trends or problems. If you’re not confident in your ability to manage the bookkeeping yourself, consider hiring a professional. Decimal’s dedicated bookkeepers can handle all your day-to-day reconciliations and ensure that your records are up-to-date and accurate.

Both the cash and accrual methods can be used with a double-entry system, but only the accrual method is recognized by Generally Accepted Accounting Principles (GAAP). The other accounting method, single-entry bookkeeping, uses one account for all transactions instead of two. This approach is less flexible and can be more difficult to audit.