New business owners have a lot to think about, and the method chosen for the business's accounting is a very important decision that should not be over looked. This decision will determine how a business records their income and expenses. The two basic schools of thought about this process are the cash and accrual methods.
The cash method is the more straightforward of the two options and is often selected by start-up companies because it is based off the business's actual cash flow. In this method of accounting the income is reported as it is received and the expenses are reported at the time they are paid out. In this method the reporting occurs at the time that cash changes hands. An example of the cash method for a sale would be if a company gets a job from a client and is paid in cash in advance that is when the income would be recorded regardless of how close or far away the job will actually be completed. From an expenditure perspective if a company purchases inventory in July but does not pay the bill until August then the expenses are counted in August.
The cash method also offers start-up companies the tax advantage of not having to pay taxes on income that has not yet been collected yet but still counts the expenses right away. As the name would imply, the cash basis is great for tracking the cash flow of a company. On the down side this method is not very good at matching revenues with the money spent on expenses that are tied to those revenues. Financial statements for companies that use this method will show the revenues and expenses when they have been received or paid out in cash. Under this method there are no receivables or payables that need to be recorded. There is also no way to track partial payments with this method.
The accrual method records income and expenses as they occur, whether or not cash has yet been replaced. For example, when a company makes a sale on credit the income would be reported in the accrual method even though the cash from that sale has not been received from the company. An example of an accrual method of recording an expense would be when inventory is ordered the expense is recorded, even though the check and therefore cash has not yet left the business to pay for that inventory.
With the accrual method taxes would be owed on income reported, even though not all of the cash has been collected by the business. This method is great for matching revenues with expenses, but not the best for keeping track of a company's cash flow. Accrual accounting is helpful in determining if a company is taking in more money than they spend, if they are staying within the budget, if there have been unexpected expenses, which expenses are getting out of control, and how they would best construct a budget for Upcoming months. Although this method is more complex it provides a business with a more accurate overall picture of the company and it's fiscal health. Financial statements for a company that uses the accrual method will match their revenues to expenses incurred while earning that revenue, and therefore will more accurately reflect the operations results. Receivables will be recorded when a sale is made, but payment is not received. Payables will also be included and will be recorded when a payment is not made when the purchase is made. Company's using this method will record the expenses and revenues in full, even if partial payments will be made over time.
So what method should a new business use? Although the answer will depend on the nature of the business and if they sell on credit or not, in most instances the cash basis is preferred for start-up businesses. If the business in question stocks inventory to sell to their customers or has sales of five million dollars or more then they are required to use the accrual method by the IRS. As a start-up company it is very important to know how much cash the business has on hand at any given moment, and that is a large reason why the cash method is preferred for start-ups. The tax benefits of not having to pay taxes on revenues that have not yet been collected are also very important. After reviewing the pros and cons of each method a business should determine which is best for their circumstances. If a company starts with a cash basis they may change to the accrual basis at a later point in time. The most important thing is to review the methods available and how they fit into the start-up company's current situation, and then make an informed decision that is the most beneficial to each company.