How Should Your Small Business Record Its Income and Expenses?
As a small business owner, you are undoubtedly looking for the smartest, cleanest, simplest ways to track your business’s financials, from your monthly balance to the number of payments on your books. But just as each kind of business offers different products and services to different target markets, there’s no one cut-and-dried way to record business income and expenses. There are however, two primary methods worth considering — cash accounting and accrual accounting. Let’s take a look at each of these methods and the distinct advantages and challenges they offer to small businesses like yours.
Cash Accounting vs. Accrual Accounting
The main difference between cash accounting and accrual accounting lies in when you record the entrance and exit of money. For instance, you might receive a request for $10,000 in products or services. You accept the request, bill for the job, perform the job, and then receive payment for the job the following month. Here’s how you would handle that scenario in both accounting systems:
- Cash accounting – In the cash accounting method, you would wait until that $10,000 actually hit your bank account. If you were the one making the $10,000 payment to another business, you would wait until you’d actually transferred those funds to record that expense. Cash accounting therefore provides you with a real-world “snapshot” of exactly how your finances stand at any given time.
- Accrual accounting – In the accrual accounting method, you would record that $10,000 as income in the month that the payer agrees to the sale — not the next month, when the money actually appears. This same principle applies to recording expenses. As you incur expenses, you go ahead record them as such on your books even if you haven’t made any payments yet.
Different Methods for Different Priorities
On the surface, this “before vs. after” difference seems straightforward enough. But each approach has different potential implications for your small business’s financial well being. The method you choose affects your:
- Cash-on-hand knowledge – The accrual method is based in part on income you don’t yet have and expenses you haven’t yet paid. It’s not very good at showing your precise current financial situation. This uncertainty can lead you to make dangerous financial errors if you’re not extremely careful.
- Big-picture viewpoint – The cash method gives you a crystal-clear perspective on your current fiscal health, but it does little to bring you the bigger picture of how your fiscal year is working out. This makes meaningful projections difficult, and it might limit your ability to qualify for a small business loan.
- Cash flow tracking – Your reported cash flow can vary wildly depending on which accounting method you use. In the accrual system, for instance, your cash flow will be reduced by any incoming bills you receive from the moment you receive them, even if you won’t be paying those bills until the following month. By contrast, the cash method will show you as being up by $10,000 with no reductions from those incoming bills.
- Taxes – Accrual accounting can give you easier control over your tax burden than cash accounting. If your year is shaping up as a high-income year, saving some of your outgoing invoices for the next year can make your books appear leaner for the current year (or vice-versa). Under the cash accounting method, you would want revenues to arrive at your company during a lower-income year if possible, instead of tacking that revenue onto a higher-paying year. But controlling your revenue on paper is easer than ensuring your payers’ behavior.
As you can see, both systems have their pros and cons, and there’s no right or wrong choice. You may want to ask your accountant about the use of a hybrid method that combines the best of both systems. One way or the other, you can find a system that makes the most sense for your small business.