For many small business owners, you do have the option to choose whether to use cash basis accounting or accrual accounting. On the other hand, if you are a larger corporation, the IRS requires you to use accrual accounting. Cash accounting and accrual accounting are two concepts that are foreign to most people, but it’s important to understand the difference. As a business owner, if you manage your books on a cash basis, you will ultimately fool yourself. Why is this?

Accrual vs. Cash 

 It’s Accrual World

When you get your credit card statement, you purchased those items last month, but the cash will not come out of your account till you pay it. In accrual accounting, you would have already accounted for that amount and planned for it to be taken out. THIS is accrual accounting.

When using the accrual method of accounting, the revenues are spread out over the period of time the service is provided, and the expenses are matched appropriately. Accrual accounting provides a much more accurate view of your finances and allows business owners to make better business decisions.

Though you may be tempted to use cash accounting, the accrual accounting method is the best way to keep your business’ financial reporting accurate. Accrual accounting will assess your revenues and expenses and tell you whether or not your business was profitable. It also allows you to see trends in your business month over month to know how the business is performing. You will notice your Gross Margin will smooth out, which gives you the most precise information to make proper pricing decisions.

Cash Basis Accounting 

Cash accounting is, simply put, a record of things as they happen: Either as cash is going out or coming in. That’s often very different from when you’ve actually earned revenue or paid expenses. There are times in your business when you either provided a service or delivered a product, and you didn’t get paid immediately. On a cash basis, this means revenue would be entered in the wrong time period. The same is true of your expenses; often, you incur expenses in one period but don’t pay the invoice until a later period.

Let’s assume that you performed services on a contract in April, May and June but did not get paid until July. If you were doing your books on a cash basis, you wouldn’t show that you earned any revenue until you actually got paid in July. April, May, and June would show no revenue related to this contract, even though you were earning the revenue as you performed those services. With this accounting method, you might think that your business was going downhill.

At the end of the day – using the cash method of accounting for your financial statements is misleading; cash accounting actually leads business owners to make the wrong decisions – around staffing, pricing, ordering, and all of the other key decisions an owner must make on an ongoing basis. We’ve created an entry-level course to help you understand, at a greater depth, the differences between accrual and cash accounting. Visit our site to learn more!