Every small business — whether a respected local mom-and-pop retailer, a startup tech company or an online venture — has accounting and bookkeeping responsibilities, including selecting the accounting method that works best for them. If you're new to small business ownership, you might not even realize that there are multiple ways to keep tabs on your company's finances.
Don't worry, though. That's where this blog comes in. As you keep reading, you'll learn more about two common business accounting methods and get helpful advice for choosing the right one for your business.
What are the most popular business accounting methods?
The cash and accrual methods are the two most popular business accounting methods. As with anything, there are pros and cons to both tactics. Let's look at what distinguishes each of them and how to determine which is the best fit for your company's needs.
First, you need to understand that each accounting method is a way to track your incoming and outgoing money.
Fundamentally, the most significant difference between these two accounting techniques is whether you track revenues and expenses when they are actually in (or out) of hand or billed. While there are many factors you'll need to consider before choosing a method for your small business, evaluating the following will help you:
The size of your business.
Your business's future growth projections.
Whether you are a sole proprietor or a corporation/publicly-traded company.
Whether you have (or plan to have) investors involved in your business.
While most sole proprietors and small businesses have the freedom to choose the accounting method they feel most comfortable with, companies with investors will likely need to use the technique that their investors want them to based on a vote.
It's also worth noting that publicly traded companies earning more than $25 million in gross revenue per year are required to use the accrual accounting method.
With that understanding, let's take a closer look at the two methods.
The cash method records revenue on the date that payment for goods or services is received and expenses on the date that an invoice for goods or services is paid. This is the easiest way to keep track of cash flow. Business owners using this method can skip steps such as journal entries and can also wait to pay taxes on revenue until payment is received. This method is ideal for freelancers and contractors, especially if clients are slow to pay. It also works well for new business owners who are just learning the ins and outs of bookkeeping.
The accrual method records revenue when a service or product is sold rather than when it is paid. This accounting option subsequently expenses on the day a transaction is billed rather than on the day it is paid, providing business owners with a high-level sense of their balance sheet. It also allows business finance specialists to be proactive in how they pay their bills to maximize cash flow. Though this method is more complicated, it is preferred by most accounting professionals because it provides a true sense of a business's financial health.
Businesses that use the accrual method of accounting have the disadvantage of paying taxes on sales that may not have been paid, so business owners or their accountants must know the status of all incoming cash and accounts receivables. Even with this downside, accrual accounting is typically the correct method for growing businesses looking to expand, hire additional employees, or seek financing or investors.
Hybrid accounting represents a combination of the two methods listed above. It is most appropriately used by businesses that stock inventory, as it allows them to track the cash coming in and going out of the company for products or services on a cash basis – but to track inventory using the accrual method. Though this combination offers significant advantages, it is a complicated approach requiring an experienced bookkeeper's assistance, either in-house or from a reputable third-party financial institution.
No matter which small business bookkeeping method you eventually choose, it is essential that you take a thoughtful approach to make your selection. Whichever technique you choose will be the one you must stick with for at least one year. You are not permitted to switch midstream, though you can adjust in a new tax year.
If you need assistance choosing the proper accounting method for your business or want to learn more about our comprehensive bookkeeping services, contact us today to set up a convenient time to discuss your needs.