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Cash or Accrual Accounting for my Business? – Do I really Care?

Guest post by: Stan Prokop

Article Overview: The article discusses how and why business owners choose, or change their accounting system, with positive and negative aspects highlighted on each choice .

Cash or Accrual Accounting for my Business? – Do I really Care?

Many business may not have even heard the terms cash or accrual accounting. They may also feel that subjects such as this are too technical in nature. However, it's an important issue for every business. It would appear that in the absence of the customer not knowing his choices that the accountants are picking the accounting method. Clearly the owner should have input into his accounting method of choice, as each method has positive and negative ramifications.

The issue of either picking the 'accrual ', or 'cash' method of accounting happens when a business is formed, as we have said. The accounting method picked simply determines how the company will record two items:

Income

Expenses

Under the 'cash method 'is usually used when a company does not have a major inventory component to their business model. Think Service Company - i.e. law firms, etc. They essentially bill for their services, or fees. A real estate firm would also be a good example of this. They sell our homes, and bill us their 'commission '.

When the company uses the cash method of accounting the business owner only records the sale when the cash comes in. Expenses are recording some time within the current year they are paid - although on occasion those expenses could be in a prior year.

What are the advantages of a customer picking 'cash accounting '. There are three main advantages:

No taxes are paid or recorded until cash received

Income can be reduced by prepaying certain expenses

The accounting system is quite simply to operate/record

Are their disadvantages to this system - yes - no system is perfectly suited. If the expense and revenues are not properly matched up the business owner, or its lenders can't get a strong handle on the true condition of the firm. You can imagine this is an important issue for lenders, lessors, bankers, etc! Also, if the business is ever sold the buyers and sellers have to pay close attention to what's outstanding in receivables and payables.

The 'Accrual Method 'is probably what most companies pick. With reference to our cash method as noted above we can say that the biggest distinction between the two is that the accrual method provides on an ongoing, snapshot type basis, a truer picture of a firms financial status. Lenders like that!

Income or sales is recorded when generated, and expenses are recorded as soon as they are payable. What are the advantages of this system? It is simply that revenue and expenses are very closely matched- owners and lenders can see what is happening. Also profit is not subject to distortions re sales or expenses that have not been booked.

In summary, as boring and accounting related as it seems, picking the right accounting method can have a major impact on how a business owners understands and presents his true financial position. The method the business owner chooses will also reflect how taxes are paid. Finally, bankers and other investors and suppliers, parties that are critical to business success, will have different insights into your business based on your choice of accounting method.

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Article Tags: accounting system choices



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