If you are a new business owner, you have already addressed several challenges about your company operations. However, one of the other challenges you need to make is deciding whether you should opt for cash accounting or accrual accounting. This choice will actually impact all your decisions, from tax filing to financial reports. Before you make a choice, you need to understand what both of them mean before you can choose one for the benefit of your company.
Kavan Choksi is aneminent businessman with entrepreneurship and financial management expert. Besides business, he is fond of travel and photography. According to him, the difference between these two accounting methods is the timing of the transactions. In cash accounting, the income and the expense only get calculated when the money switches hands. For instance, when the customer pays for the products or the supplies. The accrual method refers to the income that is gained when the work is done, and the expenses or supplies have been acquired irrespective of when this money has been exchanged.
For instance, you can take the example of a contractor who finishes a job worth $10,000 in July. However, he is not paid till August. With cash, he would have recorded the income in August, when he got the payment, but with the accrual method, he would have recorded the payment in July, when he sent the invoice for the work.
Pros and cons
The biggest benefit of using cash methods for your business is that it is simple. You know the true picture of how much cash your business has. The only problem you face is that it will show you incorrect profits and losses every month. Take the above example of the contractor only, say he spend $2000 out of the $10000 job, so the income report of July will show a negative sum of $2000 while the income record for August will display a profit of $10,000. So, in one way, cash accounting does not show you a true picture of the company’s net revenue.
In the case of accrual accounting, you will find the opposite is true. So, both the income and the expense for this service or job are recorded as the work is done. This gives you a true picture of the profit margins your company enjoys. It is simple for you to check the expected payments along the road. The only disadvantage of the accrual method is that you have to pay attention to the cash flow. You might have many invoices in thousands of dollars; however, your bank account might be empty when you wait for customers to pay you.
Kavan Choksi states that when you wait for your customers to make your payments with the above method, you must ensure that your organization’s payment collection process is well-structured. Your bookkeeper needs to review all the unpaid invoices of your company at the year-end and write off any determined amount as uncollectible for you to avoid paying income taxes. In case you neglect this, you will land up paying taxes on payments that you have not collected (your income).