Many small business owners are unaware that they have a choice as to which accounting method to use – cash basis or accrual basis. Here is a simple explanation and guidelines to help you decide which might be the right one for you.
Cash Basis Accounting recognizes expenses when they are paid rather than when they are incurred, and revenue when it is received and deposited, rather than when it is earned. It is a simple method of accounting, mainly used by small business owners. Therefore, with cash basis accounting, there are no accounts receivable or accounts payable.
Cash Basis Accounting can result in what some refer to as a “hockey stick.” Take for example, your general liability insurance policy. A business may be in a strong cash position and opt to pay for that entire policy in one lump sum. The result is the income statement will show one large payment in one month versus 12 equal payments over the 12-month term of the policy. In other words, the annual insurance payment is reflected in the month it was paid vs. being spread over the entire year. This would result in a graph that looks like a hockey stick — a sharp increase in expenses in one month followed by no expenses for the rest of the year.
The upside of cash-basis accounting is that it is quite simple and straightforward. The downside is that it doesn’t provide a realistic view of your business’s financial standing.
Accrual basis accounting recognizes expenses when they are received and revenue when it is earned (invoiced). This means a business using the accrual basis accounting method reports both accounts receivable and accounts payable on its balance sheet.
The accrual method offers a higher level of financial accuracy and also presents a greater level of financial sophistication. It allows business owners to get a much more realistic view of revenue and expenses in any given period — something that is not as visible using the cash basis method.
One advantage of this type of accounting is that it flattens out expenses so they are evenly distributed across the months. If we employ the same general liability insurance example as above, using the accrual method, the entire payment for the annual policy renewal would be captured in a prepaid expense account and then, over the 12-month policy period, the business would recognize one-twelfth of that expense each month to provide a much more realistic view of actual monthly expenses.
One disadvantage to using the accrual method is that it does not afford a business any greater awareness of current cash flow. This means a business should also carefully monitor its cash position regularly.
Determining which method is right for your business depends on how critical it is for you to predict expenses accurately as well as the level of financial sophistication you desire.
If you are a small business with lower revenue and no payables, cash-based accounting may be the right approach.
If you are a contractor juggling multiple jobs, for example, and need to understand job costing, you will benefit more from the accrual method.
Whichever method you adopt, rest assured that ARI is here to help you take better control of your accounting function and provide you with the expertise and guidance to better understand your financial statements.
Together, we can determine the best accounting method for your business goals. To explore if ARI can improve your business’s accounting practices, contact us today.