When setting up your business’s bookkeeping, one of the decisions you will have to make is choosing your accounting method.

The two main accounting methods are Cash Basis and Accrual Basis.

Each method has its pros and cons and depending on what type of business you have, one might be more beneficial than the other.

But first, what is the main difference between the two?

The main difference between Cash Basis and Accrual Basis is the timing of when transactions are recognized.

For Cash Basis, the transaction is recognized when cash is received (income) or paid (purchases).

Accrual Basis, on the other hand, recognizes transactions when they are earned (revenue) or incurred (expenses).

Let’s imagine a business with a utility expense for the month of March. As the month progresses, the business will incur an expense for the utilities used for that period.  The utility provider will send them a bill dated March 31^st, but the business won’t pay the bill until April 10^th.  

When entering the transaction using the Cash Basis, the expense will be recognized in the month of April instead of the month of March.

If the business is using the Accrual Basis Accounting Method instead, the expense would be recognized on March 31^st as that was the date of the bill and the month the expense was incurred.

But what would each accounting method mean for your business? Are there pros and cons? Do certain businesses benefit more depending on what accounting method they choose?

Now let’s dig deeper into each method and find out!

Cash Basis

Because the Cash Basis recognizes transactions when cash comes in or out, the bookkeeping process is much easier. After all, you simply book expenses and deposits whenever they clear the bank. Pretty simple and straightforward! This also means that you would have fewer month ending adjusting journal entries to worry about.

On the other hand, because transactions are only recognized when cash comes in or out, you could have an inaccurate picture of what your actual expenses are each month. Why is that?

If we go back to the utilities example in the beginning, let’s say that your business has been unable to pay utilities for three months (March-May). When you’re finally able to make a payment in June, the utilities expense entered is three times the usual amount!

This means that your expenses for the month of June will be significantly overstated, while the months of March, April and May have no utility expenses booked. For those three months of utilities missed, expenses are understated.

This accounting method works great for small businesses looking to save time and money on their bookkeeping. It provides a simple overview of the money you have coming in, out and how much is left over. This is still very helpful information and will help you run your business better! 

Accrual Basis

In contrast, the Accrual Basis recognizes transactions when they are earned or incurred to provide a more accurate picture of the profitability of your business. This is because you’ll be aligning the revenue your business earned with the costs your business incurred for the same period. As a result, you will have a more accurate net income or loss figure.

Additionally, this method of accounting will help you efficiently keep track of your Accounts Receivable and Accounts Payable.

Whenever you provide a service or product to a customer, you can immediately record an invoice for that sale, even if your customer hasn’t paid yet. Then, with an accurate Accounts Receivable Aging report, you’ll be able to see exactly how much your customers owe and the age of your receivables. This makes it easy to manage receivables and collect from customers in a more timely fashion.

In the same way, this method allows you to record bills for purchases from your Vendors before they need to be paid. Whenever you want to know exactly how much you owe your vendors, you can take advantage of the Accounts Payable Aging report that would then help you manage your expenses and keep enough cash in reserve to cover your obligations. This will also provide the information you need to pay your vendors on time, so you can keep vendor relationships on good terms. 

One of the disadvantages to this accounting method, however, is that it is time consuming and thus a more expensive method of accounting. It requires more steps to record transactions and more manual journal entries at month’s end. 

All in all, the Accrual Basis will help you evaluate your financial statements without the timing differences that occur with the Cash Basis, giving you a clear picture into your true profitability. As they say, money in the bank doesn’t mean your business is profitable. The Accrual Basis helps you fully understand how your revenue and expenses relate to each other so you can make effective decisions to improve your bottom line.

If you’re still struggling as to what accounting method would work best for your business, we’d love to help! Schedule a consultation with us and we can walk you through your bookkeeping set-up so you can be all ready when it’s time to open your business.