When first venturing into the business world, entrepreneurs must make some tough decisions. One such decision that greatly impacts the future of the business is deciding what accounting method to adopt. In the business world, there are two accepted methods of accounting available to businesses. These are accrual-based accounting and cash-based accounting.
What Is Accrual Accounting?
Accrual accounting is the method of accounting where earnings and expenses are recorded when a transaction occurs. For example, a business buys $2,000 worth of inventory from a vendor on 1st January but makes the actual cash payment on 1st February. The expense would be recorded on 1st January, the date the expense was incurred, rather than 1st February when the actual payment was made.
Features of Accrual Accounting
Complex and Resource-Intensive
Accrual accounting is more complex compared to cash accounting, and as such requires more knowledge and attention to detail. There is an increased amount of paperwork, as well as an additional record to be maintained for cash flow. A dedicated bookkeeper is necessary for a scaling business to maintain this accounting method. Large corporations and publicly traded businesses commonly make use of accrual accounting.
Paints a More Accurate Financial Picture
By recording income and expenses at the time they are accrued, i.e., the income is earned rather than cash received, and the expense incurred rather than cash paid, the business can form a clearer picture of their financial activity over a period of time. This can reveal useful information such as peak-seasons and off-seasons for the business by analyzing client spending habits. This is not possible under cash accounting as there is no record kept of the actual transaction and only of the cash payment.
Adapts to Business Scale
One major feature of accrual accounting is the fact that businesses that generate a gross yearly revenue of $25 million are required to use this method by the IRS. Because of this requirement, small businesses that are scaling must eventually adopt accrual accounting. The business may manage to cross that $25 million line sooner than expected. Adopting accrual accounting from the start means there is nothing to worry about when scaling.
What Is Cash Accounting?
Cash accounting is the method of accounting where income and expenses are recorded when a cash payment or receipt, respectively, takes place. With cash accounting, the electricity bill for January for which the payment is being made in early February will only be booked as an expense in February, whereas, with accruals accounting in place, the bill will be booked as an expense in January’s monthly closing because at the end of January, this bill has become due and hence needs to be accrued even though it will not be paid until early February.
Features of Cash Accounting
Simple and Less Resource-Intensive
Cash accounting is simpler as it just requires tracking and recording cash flow. Unlike accrual accounting, there is no tracking of receivables and payables. Cash accounting does not demand a dedicated bookkeeper and entrepreneurs can handle it by themselves easily. Because of these reasons, cash accounting is the method of choice for small businesses.
Easier Income Tax Protocol
In cash accounting, only money that has been received is taxed. On the flip side, in accrual accounting all transactions are taxed regardless of their payment status. For start-ups with restricted cash flow, this can prove helpful in keeping the business going.
Lack of Accounts Payable and Receivable Records
Since cash accounting does not require recording the date and time of invoices, there is a lack of accounts payable and receivable records. This deficiency can lead to problems down the road when payments are delayed, or bills are pending.
What’s Best for Your Business?
There are many factors to consider when deciding between cash or accrual accounting for a business. Generally, small businesses that do not consistently maintain large inventories and largely use cash would find cash accounting to be the optimal method. These small businesses must remember, however, that scaling may lead to a shift to accrual accounting that can prove tedious.
Businesses earning over $25 million are required by the IRS to use the accrual method of accounting. Small businesses may also make use of accrual accounting, and businesses looking to scale and cross the $25 million threshold would find accrual accounting the better option so that there is no need for a change later.
Small Businesses and Accrual Accounting
While accrual accounting seems like the best option for any business in the long-run, small business owners do not opt for it, mainly because of the extra cost associated with the process. The cost of a dedicated bookkeeper is often too high, while not hiring one leads to process inefficiency. Fortunately, there is an easy solution to this conundrum: Staff augmentation!
Staff augmentation refers to hiring manhours and/or expertise from a third-party service provider to enhance capacity. Many small businesses today leverage “staff augmentation services” as an instrument to step up their competitive strength. When it comes to staff augmentation services, accounting is one of the most popular choices. EA publication “Why staff augmentation is vital for US companies?” elaborates the significance of staff augmentation for US companies in the prevailing business context.
Leveraging EA’s staff augmentation services for your accruals-based accounting needs means you will have accounting and finance professionals at your disposal at just 40 percent of the US cost.