September 26, 2022
When you’re a small business owner, it’s inevitable that you’ll have to review financial statements or tax returns at some point. The way you review your finances depends on which accounting method you use for your business: accrual-based accounting or cash-based accounting. Not sure what the difference is? Not to worry! In this blog, we discuss both methods so you can better understand how to manage your finances.
First, let’s define the two terms:
Accrual-based accounting records revenue (money coming in) and expenses (money going out) when the transaction happens —not when the money lands in or leaves your account.
Cash-basis accounting records revenue and expenses when the money changes hands.
So what does this look like in practice? Let’s start with accrual-based accounting.
Let’s say you’re a shop owner and you place an order for more product. You then receive an invoice from your supplier on July 1 stipulating that you have to pay for the product in 60 days. Accrual-based accounting means the expense occurred on the date the invoice was received. So in this case, you’ll record the expense for July 1, even if you don’t actually pay for another 60 days. The reverse is also true: if someone buys something from you and you invoice them with a payment due date in 14 days, you’ll still record the revenue from the day you sent them the invoice.
For cash-basis accounting, it’s the opposite.
Even if you receive the invoice on July 1, you won’t record the expense until you pay for the product in 60 days. Similarly, if you invoice someone, you won’t record the revenue until the person pays you and it lands in your bank account.
To put it simply, the primary difference between accrual and cash-basis accounting is when you record the sale or expense.
Understanding this difference is important because it tells you when your money is coming in and going out and what insights you can glean from that data. This data then helps you make informed financial decisions so you can better achieve your business goals in the short- and long-term.
Most small businesses use cash-basis accounting because it’s operationally easier (you just need to look at your bank to track revenue and expenses) and it helps you understand how much cash you have on hand right now. On the other hand, accrual-based accounting often shows clearer long-term linkages between your expenses and revenue, which can help you better understand your business’ profitability over an extended period of time. Regardless of which method you use, either will work well for your business as long as you or people you trust are reviewing your accounts consistently.
Our team works closely with small businesses to set up and maintain financial infrastructure, interpret financial information, and provide recommendations that can improve business’ financial health. If you’re looking for support in these areas, reach out to our team.
