Setting up a business and deciding which method of accounting has a considerable impact on how your financials look.
The critical difference between these two methods is timing.
- With the cash method, you would recognize revenues and expenses when cash exchanges hands
- With the accrual method, revenue is recognized when earned, and expenses are recognized when they occur, despite no cash exchanging hands.
Cash basis accounting is easier to use, but accrual accounting shows a better picture of how well (or poorly) the company is doing.
With the cash method, you will always know how much actual cash your business has, but your profit and losses would be inaccurate and your profit margin. For example, you spent $3,000 on supplies for a roofing job in August and invoiced $12,000 for that job, but you won’t get paid until September. That means, in August, you’ll have a negative cash flow of $3,000 while September shows a profit of $12,000 under the cash method.
The accrual method would help smooth this out by allowing you to record both the expense and revenue in August—so you would net $9,000 for that month.
You get a more realistic picture of your profit margins by recording income and expenses for a job or service when the work is done. You can easily see what payments are expected in the following months, which helps to budget and plan for your business.
A Word of Caution
You’ll have to be cautious, though, and pay attention to your cash flow, accounts receivables, and accounts payables. That means staying on top of invoice collection and bill payments. Otherwise, you could end up paying taxes on the income you never received.
Our Recommendation for Which Method to Use
The cash method is the preferred method for sole proprietors and small businesses because it is so simple. But if you want to analyze, budget, and plan for your business, it is best to use the accrual method since it shows a better picture of your business’s cash flow, profit margin, and overall health.
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