There are two primary methods of accounting for the income and expenses of a business: cash and accrual. In general, if your company’s revenue is less than $5 million per year, you are free to choose either one.
Cash Accounting
Cash accounting is the more common choice for small business accounting. Income is not reported until the money hits the bank account, and expenses are not reported until they are paid.
If the company earns $50,000 in revenue during November, but doesn’t actually receive the money until January, that income would not be reported until January. But say the company had $30,000 in expenses related to that $50,000 in revenue, that they paid in November. They would report the $30,000 expense in November immediately when it was paid.
For companies that are growing, cash accounting is beneficial for tax purposes because it can defer income. In a sense, using the cash basis offers a more accurate picture of the cash-flow situation of a business. Accounts receivable may be considered an asset, but money only becomes real once it hits the bank account.
Accrual Accounting
For companies that use accrual accounting, income and expenses are reported when they are booked or when the sale is made or delivered. In the above example, the company booked and delivered a $50,000 job in November, but wasn’t paid until January. Since that income represented November work, under the accrual basis, it was accounted for in November.
The benefit of accrual accounting is a much more “real-time” look at how the business is performing. Income and their related expenses are often booked in the same time period, so business owners can get an accurate look at their margins. The downside is companies may be over-reporting their income if some receivables don’t materialize when they’re due.
Enron is the famous example of accrual accounting gone wrong, banking millions of dollars in revenue on their financial statements that they were many years away from receiving, if they received it at all.
Which is Better?
Both the cash and accrual methods have their pro’s and con’s. I use the cash basis for tax reporting because it allows me to defer a lot the income that was “earned” in Q4, but not paid until Q1 of the following year, while still deducting the expenses related to those earnings because those are paid right away.
But I also keep a separate set of books on the accrual basis, to see a month-by-month snapshot of income vs. related expenses. There’s no reason you can’t do both, because it’s important to see where your business stands both from a cash-flow perspective and from an ongoing profitability perspective.
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Tags: accounting, Entrepreneurship, taxes
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