In launching a new business, be it a consulting agency or web design firm, it’s imperative to have a fundamental understanding of accounting concepts and terms. To this end, we’ve decided to outline the ABCs of small business accounting. We will discuss basic concepts such as assets, liabilities, net worth, and revenues.
To kick off, let’s take a look at cash vs. accrual accounting.
Cash Accounting
Cash accounting refers to a method in which receipts are recorded during the period they are received and expenses in the period in which they are paid (i.e. when the cash is received for a sale, it is recorded in the accounting books). The income measurement, in this case, is based on cash flows.
Picture this scenario: You are managing the books at a convenience store. A customer enters, buys a pack of gum, and leaves. You immediately record that purchase as revenue. This is cash accounting.
Accrual Accounting
Accrual accounting, alternatively, recognizes economic events regardless of when the actual transaction takes place. This method allows current cash inflows/outflows to be combined with future cash inflows/outflows, thus giving a clearer picture of the company’s current financial condition. Accrual accounting is considered the standard accounting practice for most companies today.
So let’s jump back to the convenience store for a second. A customer enters, takes a pack of gum, and you mutually agree that he will return in 5 days to pay for it. You record the economic event that day with the understanding that the customer will return in 5 days with payment. This is accrual accounting.
Which is better?
While cash accounting may be a more clear-cut process, it doesn’t necessarily meet the needs of increasingly complex business transactions that are common today. Most businesses run on credit, offering services that continue for an extended period of time. As a result, a company’s financial condition is directly affected at the point of transaction. For a services company with a 30-day agreement, the business purchasing the service gets 30 days of work before they are invoiced. 30 days from the start of the agreement, the purchasing company is invoiced. After another 30 days, the invoice is paid.
Cash accounting adds that revenue to the books after 60 days when the cash is in the bank. Accrual accounting counts the revenue after 30 days when the invoice has been sent but before there is cash in hand.
Accrual accounting enables you to see your company’s real-time financial health. The downside to this method, however, is the fact that you are accounting for cash that is not yet available. This can be problematic if you are experiencing short-term cash flow gaps.
Cash accounting only looks at what is coming and going at any given point while accrual accounting provides better insight into your business’ fiscal standing. Fortunately, many accounting systems for small businesses are equipped to provide accrual calculations so the business owner does not need to understand all the ins and outs.
Now that you’ve mastered the concept of cash vs. accrual accounting, let’s discuss the Owner’s Equity Formula, the Statement of Owner’s Equity, the Balance Sheet Formula, and other helpful equations. Fundamentally, accounting comes down to a simple equation. Assets = Liabilities + Equity.
It seems simple enough but let’s really break it down. What do these terms mean in relation to your business and how can they help you make sense of the books? Keep reading here.
Disclaimer: Fundbox and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
