How to Choose Between Cash and Accrual Accounting to Manage Your Finances
If you are like many e-commerce business owners, you probably don’t give much thought to how your Chart of Accounts is set up or how your financial reports are structured.
However, when the time comes to sell your business, this can end up costing you thousands of dollars and even delaying the sale.
Let me explain. There are two types of accounting methods to record transactions – cash and accrual accounting. Both methods help businesses keep track of their finances and ensure that you can accurately report your taxes.
However, each method has advantages and disadvantages. In this post, we will take a closer look at both accounting methods to help you choose the right one.
What’s Cash Accounting?
Cash accounting is straightforward and easy to understand, which can be appealing to some small businesses. It’s also similar to how many people manage and track their personal finances.
When using cash accounting, you record revenue when you receive money from your customers. You record expenses when you make payments to suppliers and employees.
Here are some examples of how you’d record and track business transactions using a cash accounting method.
- You receive a bill for $200 from a supplier in April, and you pay it in May. You’d record the $200 expense in May.
- You sell $600 of products on Amazon in May, but your next settlement does not post until June. You would not include any of these sales in May.
- You were billed $100 from a supplier in May, but payment isn’t due until June. Since you haven’t paid yet, you wouldn’t record this in May.
What’s Accrual Accounting?
When using accrual accounting, you record revenue when it’s earned, such as when you deliver a product to the customer. Often, you record the revenue before the money is received. You also record expenses when they occur, regardless of whether any money is paid at that time.
The accrual accounting method is recommended for most e-commerce businesses because it can provide a more realistic picture of income and expenses during a set period. This helps companies understand a long-term view of their business that is harder to capture with the cash accounting method.
Here is how you’d record and track business transactions with the accrual accounting method using the same scenarios discussed in the cash accounting examples.
- You receive a payment of $1,000 in May from an invoice you sent in April. You wouldn’t record a revenue of $1,000 in May because you would have already recorded it in April.
- You receive a bill for $200 from a supplier in April, and you pay it in May. You wouldn’t record the $200 expense in May because you would have recorded it in April.
- You send an invoice for $600 to a client in May, but they do not pay during that month. You would record the money in May because that’s when you sent the bill.
- You were billed $100 from a supplier in May, but payment isn’t due until June. You would record the expense in May because that’s when you received it.
In the above example, the business would record a net profit of $500 for May.
Key Differences of Cash vs. Accrual Accounting
There are disadvantages and advantages to each accounting approach. Here are five key differences between them to help you determine which system is right for your business.
1. When You Record Transactions
A primary difference between these two methods is when you record transactions—both income and expenses. The cash accounting approach allows you to record revenue and expenses when money is exchanged. The accrual accounting method requires you to record revenue and expenses when they occur, regardless of whether money is paid or received at that time.
As a result, cash accounting leads to a more immediate acknowledgment of revenue and expenses. The accrual accounting approach focuses more on anticipated expenses and revenue.
2. How You Report Your Taxes
Another difference between these approaches is how they may affect which tax year certain revenue and expenses are recorded, especially for December. For example, if you bill a client $6,000 for a service in December and they pay it in January, it may or may not appear on that year’s taxes.
If you use a cash accounting approach, you wouldn’t record the transaction until January. Businesses that use accrual accounting would record the transaction in December, even if they don’t receive the money until January.
3. Influences the Appearance of Your Cash Flow
The appearance of your cash flow can differ between the two methods at any given month. This happens because the timing of when you record income and expenses varies between the two methods. As a result, this can impact how you evaluate your business’ finances.
For example, an advantage of cash accounting is that you can easily monitor your cash flow, which can help you make decisions about the current state of your finances. However, keep in mind that sometimes it can be misleading if bills haven’t yet been paid.
Because accrual accounting doesn’t account for when money is received or spent, it’s important to have some way of keeping an eye on your cash flow. Otherwise, there’s a risk of having a short-term cash shortage if revenue isn’t coming in fast enough compared to expenses.
4. Evaluate the Profitability of Your Company Over the Long Term
Accrual accounting is popular because it makes it easier to evaluate a company’s earnings over time. This method helps smooth out earnings over time since you see revenue and expenses as they are generated.
5. Accrual Accounting is Required for Some Businesses
Some companies in the United States and Canada are required to use accrual accounting. For instance, the IRS mandates that corporations with average annual gross receipts exceeding $25 million for the three preceding tax years may not use a cash accounting method. Additionally, if you carry an inventory and sell merchandise, you may be required to use the accrual method.
Understanding the differences between cash and accrual accounting helps you choose the right approach for your business.
Cash accounting gives you a more day-to-day view of your finances, whereas accrual accounting requires you to track invoices instead of your bank account.
The more you understand the advantages and disadvantages of your chosen accounting method, the better you’ll be able to evaluate your business’ finances to help you make key decisions.
Overall, accrual accounting is typically the most commonly used method. However, small businesses that need to carefully track their cash flow to prevent problems with their overall workflow may benefit from cash accounting at first.