You can have the same amount of money flowing in and out of your business, but did you know that the way you choose to account for that cash-flow in your books can affect the tax due on your return?
Beyond the obvious financial decisions a company must make regarding their accounts, like budgeting, every business should take a careful look at their method of bookkeeping and decide whether the accrual or cash method would be more suited for their business. To do that, however, you must first understand how both work.
The Cash Method
The cash method, as the name suggests, is a form of bookkeeping that simply accounts for income and expenses as they happen. For instance, if a product is sold, the income would only be recorded after the money has been received, while expenses are counted only after the bill has been paid.
Commonly used by individuals or small businesses, the cash method is a great way to have a grasp of a company’s financial state in real-time. However, one disadvantage to cash accounting is that it can be deceiving in the long-run, as it can show that a company has plenty of cash coming in, when in reality, the long-term expenses far outweigh the revenue.
The Accrual Method
The favored method by many large companies, accrual accounting focuses on recording all income and expenses, even before the money ever changes hands. As this offers businesses a broader financial picture in the long-term, accrual accounting can often help companies plan for growth and avoid potential pitfalls down the road – though it can be difficult to implement correctly.
One disadvantage to the accrual method, however, is that because the money is accounted before it’s deposited into the bank, businesses can run into a potential cash shortage for a small period of time, even though their records show an increase in income.
Choosing a Method
As both methods have their own advantages and disadvantages, it can be hard to choose which process to use for your own business – especially as U.S. tax code requires businesses to choose only one under the “matching principle”. This standard states that expenses should be recognized when the income that creates those liabilities is recognized. Without matching revenues and expenses, the overall activity of a business would be greatly misrepresented from period to period.
However, a simple rule of thumb is that if your business is small (thereby not publicly traded or making large financial disclosures), the cash method might be best for you. And for large companies? Consider accrual accounting.
Need help handling your bookkeeping? Call us at (310)534-5577 or send an email to [email protected]! We’d love to hear from you and look forward to helping you or your business achieve your financial goals.
