Know the Difference Between Cash-Based and Accrual-Based
In the beginning, using cash-based accounting may work well for a small business to keep their financial records. In using this method, cash is recorded whenever it's received from customers for products or services or paid by the business to cover expenses. With cash-based accounting, the business owner is tracking the literal incoming and outgoing flows of cash.
Tracking these cash flows is the benefit of using cash-based accounting. At all times, you know how much cash you have on hand to pay bills and can physically see cash accumulate via sales. It keeps the small business owner from spending what they don't have, especially if no money is coming into the business.
The drawback to cash-based accounting is the inability to see how the expenses help to draw in revenues. Cash spent in one period for inventory or other necessary expense for business operation may not create revenues immediately. Once the revenue is realized, it's difficult to go back to determine the exact source of its occurrence.
After some time, the small business owner may choose to switch to accrual-based accounting to better manage the financial records as the business grows. With accrual-based accounting, all transactions are recorded at the time they are recorded regardless of whether payment is made or not. The small business owner is tracking the revenues the business has earned, even if no cash has been received.
This is where accrual-based accounting falls short. The small business owner can complete many jobs and send out many invoices, but without any actual payments, the business is only profitable on paper. While the accounts receivable may be growing, so will the accounts payable. A business needs cash flow to remain viable, not promises of cash flow.
However, accrual-based accounting trumps cash-based accounting when it comes to connecting the dots of revenues and expenses. Accrual-based accounting allows the small business owner to see a direct correlation between funds paid out for expenses and the effects on revenues. Also, the current period's performance can be easily compared to performance in prior periods.
Regardless of your choice, Equitable Bookkeeping can help you keep track of your finances. Just remember to speak with your accountant to determine which accounting method works best for your business.