Accounting: Cash vs. Accrual

One of the biggest factors in getting a system is your accounting method. There are two types of methods which are Cash Basis and Accrual Basis. Knowing which type of method your business runs off may affect how you view getting a system. Generally Accepted Accounting Principles (GAAP) are the standards used in the United States to provide uniformed accounting and financial statements. GAAP approves the accrual, not the cash basis, method of accounting. However, many non-incorporated small businesses use the cash method of accounting with no problems. When a small business starts to grow, getting loans and investors, it may consider using the accrual method  which is mandatory if your business has sales of more than $5 million, or if you have inventory and sales of $1 million on an annual basis. It is important you understand the two different systems and their  principal methods of how they track income and expenses. The big difference in these two system is the timing in which your sales and purchases are a credited and debited to your accounts.

Here is how each method works:  

Cash-basis accounting: Expenses and revenues aren't carefully matched on a month-to-month basis. Expenses aren't recognized until the money is actually paid out, even if the expenses are incurred in previous months; and revenues earned in previous months aren't recognized until the cash is actually received. However, cash-basis accounting excels in tracking the actual cash available.

Accrual accounting:

Expenses and revenue are matched, providing a company with a better idea of how much it's spending to operate each month and how much profit it's making. Expenses are recorded (or accrued) in the month incurred, even if the cash isn't paid out until the next month. Revenues are recorded in the month the project is complete or the product is shipped, even if the company hasn't yet received the cash from the customer. The accrual method is a GAAP approved accounting practice, gives a better idea of real income and expenses within a time period, and gives a clear long-term picture of the business, unlike the cash method. The disadvantage is that cash flow not always clear. If you don’t have a “buffer” in your bank account, you could potentially put yourself in a cash poor situation.

Each accounting method has its benefits and limitations. Many accounting packages allow you to switch between calculating reports in cash or accrual basis at the click of a button. Understanding basic cash flow reports will help you with day-to-day management. Using the accrual method will give you better insight into past performance and future forecasting (which aids in planning for business growth). It is recommended that you use a mix of the two methods internally so you can have a both a “big picture” and a daily realistic view of your company’s income and expenses.