As businesses grow, their financial needs change. Whether a company is experiencing an explosion in revenues or needs an accurate financial outlook for budgeting, it is vital that the right type of accounting is utilized to track income and expenses.
Most small businesses will start with a simple cash basis method; however, overtime they may need better insight into the financial health of the company to help facilitate growth.
As a business owner, how do you know which accounting method is best for your business and when is it time to make the switch? Keep reading for how to best answer these questions...
What is Cash Basis Accounting?
This is the simpler of the two accounting methods and so it is often favored by small or early-stage businesses. With this accounting method, the cash inflows and outflows of the company are recorded and then reconciled.
To put it another way, revenue is recorded when cash is received and expenses are recorded when payments are made. In this simplistic method, there is no integrated record of accounts receivable or accounts payable and so that information is generally recorded separately.
What is Accrual Basis Accounting?
This is a more advanced way to handle the accounting. With this method, all transactions are accounted for when the transaction occurs or is earned to more accurately report on the financial results of a company, and not the actual money in hand.
For example, when a sale is made, that revenue is recorded -- not when the invoice is paid by the customer. The same is true for expenses which are documented when goods or services are received by the company.
This method of accounting provides a better financial picture of what is happening in the business. Some of the specific benefits of the accrual basis method include:
- Consistency. If expenses and revenue are always recorded at the point of sale, then it makes future financial planning easier. Just looking at the cash on hand in any given moment does not provide an accurate depiction of the average activity a company is experiencing, or what future inflows or outflows will be.
- Greater financial opportunity. Banks and other lenders usually want to see the accrual method of accounting for companies before making a decision.
- Better analysis. When companies can align their revenue and expenses within given time frames, they can better analyze how much profit was gained.
Cash Versus Accrual Basis: Which Is Best For My Business?
To understand which form of business accounting is the best fit for your company, you should first figure out which could be most beneficial based on your company's current standing and future goals. Start by asking yourself these questions:
Is my company required to use the accrual method for tax purposes? There are certain cases when the accrual method is actually required to be tax compliant. Those include:
- Companies with inventory/goods
- Companies that are C corporations
- Companies that have excess of $5 million in gross sales revenue. This is not as cut-and-dry, so you will want to talk with a tax professional to determine if you fall into this category or not.
Who needs to know my company's financial information? If a small handful of internal management look over financial information for pretty straightforward decision making, then the cash method could be appropriate; however, management will be limited to the financial information available when making decisions.
Related Article: Dollars & Sense: How to Build an Accounting System for Startups
In cases where there are external stakeholders that need to be privy to your company's financial information (i.e., investors, banks, advisors, etc.), you will want to utilize the accrual accounting method. This method will provide insight into what shape the company is in financially. Furthermore, using the accrual method shows external stakeholders that the business has the financial savvy to grow.
Where do I want my company to be in 5 years? If you are happy with the current number of transactions and do not foresee much growth in your business in the future, then a cash basis method could be the right fit; however, if you have goals to advance your company beyond its current revenues--particularly if you think that revenue will rise above $5 million--it is best to implement an accrual method as soon as possible. Using the accrual method of accounting will provide a better picture into the financial results of the company which allows internal and external stakeholders to better analyze operations, make more informed decisions, and grow the business.
Transitioning from Cash to Accrual Basis Accounting
Transitioning from a cash basis to an accrual basis method of accounting can be a daunting task, especially if your internal accounting resources are limited. In these instances, it may be worth seeking guidance from an outsourced accounting team. They can facilitate the transition and then also provide the ongoing accounting support and financial analysis necessary to effectively run your company, analyze operations, and guide business decisions.