What Are Cash Accounting and Accrual Accounting?
These are the two options you have for keeping track of money coming into and going out of your business. The essential difference between these two methods is the timing of when you "earn" or "spend" money. With cash basis, you earn money on the day you receive it and you spend money on the day you pay it. With accrual basis, you earn money on the day you invoice the client and you spend money on the day you agree to pay for something.
Here are two examples, one for income and one for expenses.
First, let's say you invoice a client for $100 on January 2nd and she pays you on January 15th. With the cash method, you earned that money on January 15th - the day she paid. With the accrual method, you earned that money on January 2nd - the day you invoiced her.
The difference doesn't matter much - except when you're trying to keep track of how you're doing each month. If you invoice the client on January 2nd and she pays on February 2nd, that money was earned in February under the cash method. And if she doesn't pay until March, it will be earned in March. Under the accrual method, the money was earned in January no matter when the client pays.
Second, let's say you put office supplies on your credit card on January 2nd. The bill comes and you pay it on February 2nd. Under the cash method, that expense happened in February. Under the accrual method, the expense happened in January when you committed to paying for the products.
Oddball Things That Happen with Cash and Accrual Methods
Personally, I think the accrual method is better for me because I like to line up income and cost of goods sold within the same month. This will never line up perfectly, but is much easier with accrual.
In my opinion, the cash method is fine if you are not good at paying attention to your financials and your bank account. But it makes it difficult to answer the simple questions
- What were your sales last month?
- What were your expenses last month?
Strictly speaking, the accrual method gives you a more accurate picture of how you did each month in terms of money "earned" and money spent. But if you don't get prepaid for all your work, you need to make sure you understand that the sales represent commitments for sales, not actual dollars in your bank account. You might have $20,000 in sales but not see the money for some time to come.
The exact opposite can happen with the cash method. You might have horrible sales in December but it looks like a great month because lots of clients decide to pay their bill before the end of the year. So all that cash "income" you earned in November and October shows up in December. Then again, the slow sales in December will make January look slow even if you make lots of sales.
The only real problem with the accrual method is when the client never pays. So, for example, you booked income in January but the money never shows up. At some point you need to write off that sale so that it reduces your earnings. Otherwise, you'll be taxed on a sale even though you never got the actual money.
Which Method is Best for You?
I don't know. Go talk to your accountant.
I'm not an accountant. I pay very close attention to my numbers. I use accrual.
There are a few choices made for you by the government. If you make $5 million or more, you have to use accrual. You also have to use accrual if you have revenue over $1 million and you maintain an inventory of merchandise.
In other words, if you're small and plan to stay there, they you can choose either method. If you are a little larger then you need to use accrual.
Go talk to your accountant so that you can make a decision and understand the consequences of the decision for you business.
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About this Series
SOP Friday - or Standard Operating System Friday - is a series dedicated to helping small computer consulting firms develop the right processes and procedures to create a successful and profitable consulting business.
Find out more about the series, and view the complete "table of contents" for SOP Friday at SmallBizThoughts.com.
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Next week's topic: Financial Goals - Realistic Revenue Projections
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Standard Operating Procedures