There are two forms of accounting methods that can be used to construct a set of financial statements for an entity; Accrual and Cash Basis Accounting. Both have their benefits and unfavorable consequences so let's take a look at both so you can make an informed decision as to which type of accounting is best for your business.
Accrual Basis Accounting
Accrual Based Accounting is an accounting principle that has various applications in the finance sector of business. This accounting method creates the basis of recording the revenues and expenses for a business's financial statements.
Ultimately, we are trying to match the revenue and expenses in the same time period when using the Accrual Method so that we have a better idea of how the business is actually performing in a specific time period.
For example, if you did work for a customer and you earned $10,000 for the month, that full amount would be recognized as revenue regardless if the account receivable has been paid or not.
The same is true on the expense side. You would accrue or book expenses as a payable in the accounting period that the expenses were created even though you may not have paid them yet.
The benefits of Accrual Basis Accounting comes down to being able to more accurately view the financial health of the business because all transactions that make up the profit for any given month, are recognized in the correct time period. What this does is allow us to really understand the profit margins of the business and adjust where we can, to increase the overall margin.
Secondly, when using Accrual Accounting, the business can show more revenue versus what a Cash Basis Method would show because we are looking at what was truly earned in a period regardless if the receivables have been paid or not. This would be a positive if, for example, you were working with a bank to get a Line of Credit or, you are selling the business and want to show that the business is making more profit than what it would in the alternative accounting method.
The downside is the inverse of above. If you are trying to avoid tax in a given time period, by accruing the revenue and expenses, you are actually creating more profit to be taxed on.
Furthermore, an investor may not want to make decisions based on "unpaid" revenue as there are company's out there that fudge their receivables. This is the main reason why an auditor should be looking at the financials to ensure that the receivables, and payables, are backed up by documentation.
Cash Basis Accounting
Cash Basis Accounting is an accounting method that recognizes income and expenses only when the cash is exchanged. This method is much easier than Accrual Accounting because it revolves around the actual cash received or paid.
The key advantage of the Cash Method is simplicity as understanding the true cash flow of the company becomes much easier when we are just recording the actual cash activity.
Another advantage would be delaying the taxes due because you aren't inflating revenue by the work you actually performed. You are only being taxed on the cash that you took into the business for that period of time.
The disadvantage of Cash Based Accounting is that it is much harder to understand the profitability of the organization.
The Best Accounting Method?
For me, as an accountant, I would much rather understand what is actually happening with the business which means I use the Accrual Basis Accounting Method the majority of the time.
The benefits of Cash Accounting are not strong enough to forgo knowing how the business is truly performing and, after the first year, pushing out the tax expense really isn't a benefit as you will be paying tax on the cash that came in the door.
Plus, if you have a good accountant, the simplicity factor isn't a real benefit either as your accountant should be able to do either method.
Also note that you can't bounce back and forth between Accrual and Cash Basis Accounting. The Internal Revenue Service's rules on this are stringent as to when you would be able to make a change.
If you need help understanding your business's accounting, please feel free to reach out to me!
Blue Collar CFO