When starting a business, one of the most critical decisions you’ll make is how to account for your company’s financial transactions. You can choose between cash accounting and accrual accounting. Although both methods track your company’s income and expenses, they differ in how they record the financial transactions.
In cash accounting, revenue and expenses are recorded when cash is received or paid. This means that if you receive a payment from a customer, that revenue is recorded in your books immediately. Similarly, if you pay rent for the next month, you record the expense only when the payment is made.
This method is straightforward and easy to understand, making it the preferred method for small businesses. It’s also perfect for businesses dealing with cash transactions, like retail and hospitality industries. Moreover, cash accounting is inexpensive and uncomplicated because it doesn’t involve extensive record-keeping. Still, it has downsides. One major disadvantage is unreliable financial reporting because it doesn’t provide comprehensive information.
Another disadvantage of cash accounting is that it doesn’t consider non-cash transactions that can impact your business, such as outstanding invoices or payments owed to vendors. For instance, suppose a customer purchases a product on credit from your store. In that case, the revenue isn’t recorded until you receive the actual payment, which can delay financial reporting.
Accrual accounting is an accounting method that records revenue when it’s earned, and expenses when they’re incurred. This means that if you sell a product on credit, that revenue will be recorded as soon as the sale is made, even if you haven’t received the payment. Similarly, if you incur an expense, like your employees’ salaries, that expense will be recorded in your books even if it hasn’t been paid yet.
Unlike cash accounting, accrual accounting provides a clear picture of your business’s financial standing. It’s also preferable for businesses dealing with long-term contracts or transactions spanning different periods, such as project-based industries.
However, since it considers all financial transactions, accrual accounting can be more difficult and expensive to maintain because it requires more extensive record-keeping. Moreover, it doesn’t provide an accurate picture of your company’s cash flow because it doesn’t record when the cash actually exchanged hands.
Still, even though accrual accounting is challenging to understand, it’s worth noting that the report accurately reflects your company’s actual position by recognizing all financial transactions as they occur. Understanding these accounting methods will help you make informed decisions about how to record transactions that accurately reflect your company’s financial position.