Most of us here are new to the business world – and therefore new to the world of business finances as well. In the beginning we will likely keep records in a very literal and chronological fashion, but as our business and knowledge grow it’s important to explore other methods of accounting that may suit our businesses better.
An important stepping stone in this journey is learning the difference between cash basis and accrual accounting. By understanding how each works and the benefits of both models, you can then decide which would be best for your situation moving forward.
Cash Basis Accounting
This method of tracking finances is probably the one you are familiar with. Cash basis accounting follows money at the time that it is spent or received. Personal finances are usually recorded this way, as well as those of smaller businesses. The cash basis approach makes it easier to follow the cash flow – seeing when and where the money is leaving or entering. This is also the simpler of the two accounting methods.
Due to its simplicity and timeliness, however, it is not a particularly strong indicator of future performance of a company. While a business might have cash on hand at the present time, there may also be a number of expenses coming up in the near future which have not been accounted for with this cash method. Without knowing what money may be coming in to cover those expenses, current financial health as shown by cash basis accounting is not a reliable predictor of what is to come.
Accrual Accounting
Accrual accounting is used more by larger companies and especially those which are publicly traded. This method records revenue and expenses when they are earned, even if the money has not yet been received or paid.
Accrual accounting gives a better understanding of the profitability of a company as well as its long-term potential. By including accounts payable and accounts receivable, we can examine what expenses and revenues are coming up in the near future and get a better understanding of a company’s stability and/or growth.
Which One Is Right for Your Business?
Ultimately, if you’re just getting started and are confused by all of the technical financial terms, sticking with the cash basis method for now and keeping flawless records is the simplest approach. By using the more straight-forward method you’re more likely to track things accurately and keep it all organized. As your business grows and you find an accountant, discuss your options with them to determine the best course of accounting for your situation.
*I plan on expanding this article in the near future with better explanations and even some examples! Stay tuned!*
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