What accounting method should a business use? One of the first decisions many business owners will make is whether to handle accounting on a cash basis or an accrual basis. What is accrual accounting, and how is it generally different than cash accounting? Why is it better for businesses that are serious about their company and interested in long-term, sustained growth and value?
3 Main Points about What Accounting Method Should a Business Use?
- Cash accounting -vs- Accrual accounting: how and when income and expenses are earned and recorded.
- Accrual accounting helps to better understand and control income and outgo, while presenting a more accurate picture of your company’s health and viability.
- If the owner(s) of a business ever intend to sell it, valuation is generally increased, and most savvy buyers will require accrual-based financials.
The Perceived Argument for Cash Accounting
The only way to answer the question of “what accounting method should a business use?” is to begin with an understanding of the fundamental differences between cash and accrual accounting, and why many smaller business owners prefer cash accounting. The short description of a cash accounting system is “money in, money out.” This feels almost intuitive and much simpler to many business owners.
Cash accounting systems are based on money moving into or out of the company’s bank account. It may seem easy to track, but it doesn’t provide the insight necessary to make important decisions, often leading to under-estimated expenses and over-estimated income.
What is the Essence of Accrual Accounting?
Accrual accounting records revenue when it is earned, and logs expenses when they are incurred, not when payments are received or made. Accountants often call this the “matching principle,” as income and expenses are aligned within the same period.
Example: A client is sold $50,000 of product in September, but payment is not received until October. In this example, accrual accounting would record the income in September, even though the client doesn’t pay until the following month.
Example: $20,000 in components required to produce the above product are received in September, but the bill is not due and paid until later in October. The expense of the components would be recorded in an accrual system in September, when they were used to create your product(s).
Cash accounting tracks the money but doesn’t really reveal profitability. If we continue the above example, your company finished the work and closed the sale in September, but didn’t receive payment until October. A cash accounting system would show no income or outgo for September in this example. An accrual accounting system would show $50,000 of income for product sales and $20,000 of outgo for components in September, resulting in an actual profit of $30,000 for September. The accrual method provides a much more accurate picture of business profitability (and loss).
Why Should A Business Choose Accrual Accounting?
What accounting method should a business use? The argument for accrual accounting from a business owner’s perspective is a more accurate financial picture and more informed decision-making. Accrual accounting doesn’t base business success or challenges on cash on hand. It shows whether your company is growing, stagnant, or losing ground. Matching revenue and expenses in the month they actually occur allows your business to identify profitable trends in product and service offerings, make forecasts, and plan budgets based on actual performance, not the timing of payment.
In addition, banks, potential investors, or even an ultimate buyer for your company will want accrual-based financial reports. Lenders need to measure true profitability and viability, not just the company’s cash balance on any given day. The cash balance in an account provides no evidence of your company’s actual financial and business health.
What accounting method should a business use? A lot will depend on the size and scale of the company, as well as future plans for growth, expansion, funding, and your ultimate exit strategy. If your company intends to carry inventory, sign long-term contracts with payments, or extend credit to potential customers, an accrual accounting system allows scalability. It will grow with you.
If you intend to seek outside financing, investment, or even sell the business downstream, an accrual-based accounting system will provide more accurate insights, decision-making, and ultimately valuation and credibility with lenders and buyers alike.
We invite you to learn more about the integrated tax, legal, accounting and business consulting services of Allen Barron and contact us or call today to schedule a free consultation at 866-631-3470. Our team of professionals can help you to analyze your unique situation, and determine the right path forward based upon your company, as well as your goals and objectives now and in the future.
