Every small business — whether a respected local mom-and-pop retailer, a startup tech company, or an online venture — has accounting and bookkeeping responsibilities, including selecting the accounting method that works best for them. If you’re new to small business ownership, you might not even realize that there are multiple ways to keep tabs on your company’s finances.
Don’t worry, though, that’s where this guide comes in. As you keep reading, you’ll learn more about two common business accounting methods, and get helpful advice for choosing the right one for your business.
What are the most popular business accounting methods?
The two most popular business accounting methods are the cash method and the accrual method. As with anything, there are pros and cons to both tactics. Let’s take a look at what distinguishes each of them, and how to determine which is the best fit for your company’s needs.
First, you need to understand that each of the accounting methods is a way to track your incoming and outgoing money.
Fundamentally, the biggest difference between these two accounting techniques is whether you track revenues and expenses when they are actually in (or out) of hand or when they are billed. While there are many factors you’ll need to consider before choosing a method for your small business, evaluating the following will help you:
The size of your business
Your business’s future growth projections
Whether you are a sole proprietor or a corporation/publicly traded company
Whether you have (or plan to have) investors involved in your business
While most sole proprietors and small businesses have the freedom to choose the accounting method that they feel most comfortable with, companies that have investors will likely need to use the method that their investors want them to based on a vote.
It’s also worth noting that publicly traded companies earning more than $25 million in gross revenue per year are required to use the accrual accounting method.
With that understanding, let’s take a closer look at the two methods.
Cash Method
The cash method records revenue on the date that payment for goods or services is received, and expenses on the date that an invoice for goods or services is paid. This is the easiest way to keep track of cash flow. Business owners using this method are able to skip steps such as journal entries and are also able to wait to pay taxes on revenue until payment is actually received. This method is ideal for freelancers and contractors, especially if clients are slow to pay. It also works well for new business owners, who are just learning the ins and outs of bookkeeping.
Accrual Method
The accrual method records revenue at the time that a service or product is sold rather than when it is paid. This accounting option subsequently expenses on the day that a transaction is billed rather than on the day that it is paid, providing business owners with a high-level sense of their balance sheet. It also affords business finance specialists with the ability to be proactive in how they pay their bills to maximize cash flow. Though this method is more complicated, it is preferred by most accounting professionals because it provides a true sense of a business’s financial health.
Businesses that use the accrual method of accounting have the disadvantage of having to pay taxes on sales that may not have been paid, so it is essential that business owners or their accountants know the status of all incoming cash and accounts receivables. Even with this downside, accrual accounting is typically the right method for growing businesses that are looking to expand, hire additional employees, or who are seeking financing or investors.
Hybrid accounting
Hybrid accounting represents a combination of the two methods listed above. It is most appropriately used by businesses that stock inventory, as it allows them to track the cash coming in and going out of the business for products or services on a cash basis – but to track inventory using the accrual method. Though this combination offers significant advantages, it is a complicated approach that requires assistance from an experienced bookkeeper, either in-house or from a reputable third-party financial institution.
No matter which small business bookkeeping method you eventually choose, it is important that you take a thoughtful approach to making your selection. Whichever technique you choose will be the one that you are required to stick with for at least one year. You are not permitted to switch midstream, though you can adjust in a new tax year.
If you need assistance in choosing the right accounting method for your business, or would like to learn more about our comprehensive bookkeeping services, contact your bookkeeper or tax preparer today!