The first few years of any business are volatile. According to the U.S. Small Business Administration (SBA), 25% of new businesses don’t survive the first two years while 50% don’t live past the first five years. In an environment made worse by the global coronavirus pandemic, small businesses face an even more uncertain future. One of the major reasons for this situation is the lack of proper accounting.
Many new business owners lose track of their finances and can’t tell if their ventures are profitable. If you continue running operations without a clear picture of your business revenues, it’s only a matter of time before everything collapses.
It’s important to stay up-to-date with their accounting processes to understand your enterprise’s financial health fully. The most commonly employed small business accounting methods are accrual or cash-based systems. These two systems differ in the timing of recognizing expenses and revenue.
Learning about cash vs accrual accounting methods, implications, and eligibility for your business gives you a clearer impression of your company’s finances.
This post delves into the two business accounting approaches to help you understand your financial paperwork. This cash vs accrual accounting information will also help you decide which accounting system is best for your business.
Cash Vs Accrual-Based Accounting Systems
Managing your income/revenues and expenses is one of the fundamental practices in business. Endeavor to account for all the money coming into your account and every dollar you spend. This is at the core of your accounting process. In the accounting practice, there are two approaches to recording income and expenses.
The first method of accounting is cash-based which only recognizes business revenues and expenses when money changes hands. When you receive a payment into your account, this goes into the accounting system. If you pay for some expense you also record this in your books. This is a straightforward accounting system where you record income as it’s received and expenses as they’re paid.
Take for instance if you sell an item for $500 on June 4th and you invoice the client. The client then pays on July 2nd. Using the cash-based accounting method, you record this as income for July.
With this method, you don’t have a place for accounts receivable or payable as you only record payments made in form of cash, credit card, checks, or digital payments. This is the accounting method of choice for small businesses such as sole-proprietorships or partnerships with less than $25 million in annual sales.
The other method of accounting is accrual-based. Here you record revenues and expenses whenever they’re billed and earned. It doesn’t matter whether money has changed hands. In our example above, the sale of an item on June 4th would mean the income of $500 goes into the financial statement for the month of June and not July when the payment is done.
This is the accounting method conforms to the Generally Accepted Accounting Principles (GAAP). It gives clarity and a short-term vision of a company’s financial situation. This approach to accounting is more accurate in showing how much money came in and what you spent within a specified time period.
Why your Small Business Accounting System Matters
Failure to account for the money coming or going out of your business sets you up for failure. The accounting method you choose affects the timing of revenues and expenses in your financial statements. This, in turn, affects your tax filing with IRS closely monitoring this.
Failure to use these methods might lead to IRS declining your returns. This puts you at risk of hefty fines or jail term. Using a consistent accounting system also helps you to better track your finances and guarantees success in the emerging post-Covid era.
Any change to the accounting system require IRS approval, a complicated process that requires you to complete file Form 3115. For this reason, choose the best system right from the beginning.
In today’s fast-paced business environment, data-driven decisions can make all the difference for your investment. Choosing a good accounting system gives you reliable data for better decision-making. The accounting system also comes in handy when applying for business funding through public or private financing.
Cash Basis Accounting
For cash-based accounting, you only record revenue when you receive cash. Similarly, you only record an expense when you pay out the cash. This is the most common accounting system used by small businesses to maintain their books and file taxes. Most people also use it to manage personal income.
- Easy record keeping: This is a straightforward accounting method where you might not even need a professional accountant. If you’re using accounting software, you don’t have to record your bills or invoices to produce financial statements.
- Keep track of your income: For business owners, it’s not easy to track cash flow but if you adopt the cash basis for your small business, you’ll always be up-to-date. You can tell the cash flow situation and this comes in handy to determine if you need small business financing.
- Work with a single-entry: You don’t need a complex accounting program for your business.
- Short-term cash flow indicator: You can get the wrong picture of your company’s long-term profitability. Without taking future expenses into consideration or income that hasn’t been paid, it’s not possible to get the true long-term analysis.
- Distorted business performance: While cash-basis is a great tracking tool, it doesn’t give the business a true picture. When last month’s invoices clear, for instance, you record them when they’re paid and this doesn’t give you a true picture of monthly trading. With the wrong information, you might start making the wrong business decisions.
- IRS restrictions: Cash-basis might be popular with small businesses, but it’s not IRS compliant for corporations, businesses that keep inventory, or with gross receipts of over $5million per year.
- You need a separate system to track the invoices you send or those received.
Accrual Basis Accounting
Accrual basis accounting is an accounting approach where you record revenue when you earn it and expenses when they’re incurred. This applies even if money hasn’t changed hands.
- More accurate impression of your business’ financial health: From your financial statements, you can tell how much money your business is owed and how much you owe. It’s also easier to access small business financing when you have accurate data.
- Easier planning: You can use data generated to make better decisions. Data-driven decisions can give you a competitive edge in your target market.
- Easier tracking of profitability: Now that you record income immediately, it’s earned and expenses when incurred, it’s easier to track profitability month by month.
- Improve your creditworthiness: If you plan to look for a small business loan, investors or lenders will get a better impression of your company through accrual-based financial statements.
- The Generally Accepted Accounting Principles (GAAP) compliant: The financial statements generated are deemed more accurate.
- Cash flow tracking issues: If you want to track your business’ cash flow, this method poses some problems. Some records on the financial statement don’t actually translate to actual cash in your hands.
- Time and labor-intensive accounting: You require trained staff and a complex system for accrual-based accounting. This approach requires frequent reports to keep track of your business performance. Enter all bills and invoices into the system and things get hectic during end-of-the month accounting.
- Risk of higher taxes: This accounting method entails recording income that you don’t have in hand. This means you might end up paying higher taxes on revenue you haven’t actually received.
- Difficulties in switching: It’s difficult to switch to accrual basis accounting from another accounting method.
- Fraud issues: Some businesses might hide fraud issues behind this accounting system’s complexity.
Choosing the Best Accounting Method for your Business
Which is the best accounting method for your business? There’s no one-fits-all accounting system for all businesses. Here are some factors to help you make the right decision when choosing between cash vs. accrual basis accounting methods:
- Nature/stage of your business: For a sole-proprietor startup, cash basis accounting allows you to track cash flow easily and doesn’t eat into your meager resources.
- For tax purposes: If you’re a struggling business and you need some relief with your tax bill, using a cash-basis method of accounting can ease the tax burden for the reporting period.
- Average income of over $25 million over 3 years: It is an IRS requirement for your small business to use the accrual-basis accounting system for this type of business.
- Inventory-heavy business: The accrual method of accounting helps give more clarity about your business performance.
- Federal requirements: Some states such as New York require accrual basis tax return filing.
- Financing requirements: If you want an unsecured loan, line of credit, or bad credit loan for your business, the clearer picture from accrual basis accounting records offers more confidence to lenders.
Poor accounting is the Achilles heel of most startups and small firms. With this in-depth review of cash basis and accrual-basis accounting systems, it’s easier for your business to track income and expenses and get an accurate picture of financial performance.
If you are looking for working capital for your business, Rapid Finance has multiple financing solutions to help your business maneuver through today’s fast paced business environment.