In launching a new business, be it a consulting agency or web design firm, you should have a fundamental understanding of accounting concepts and terms. To this end, we’ve decided to outline the ABCs of small business accounting. In this series of posts, we will discuss basic concepts such as assets, liabilities, net worth, and revenues. We are keeping things simple and will avoid discussing concepts that are irrelevant to most small business owners.
To kick off the series, let’s take a look at cash vs. accrual 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, 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 (Quicken, QuickBooks) for small businesses are equipped to provide accrual calculations so the business owner does not need to understand all the ins and outs.
*Note that in the US today, the IRS actually mandates business’ to adopt accrual accounting if that company has more than $10 million in annual gross receipts.