Accounting Methods: Cash, Accrual or Prius – What’s Best for You?
As a small business owner, it is important to keep accurate financial records. Not only are they required for tax compliance, they are essential to managing your cash flow and growth. Generally, if your gross receipts are under $25M per year, and you do not produce, purchase, or sell merchandise, you can use the cash method for tax compliance. Many small businesses take advantage of this, but it may not be the best method for internal management.
What is the Cash Method?
Cash basis accounting records business activity as the cash passes through your hands. When you pay an expense, it is recorded on the date it is paid. Likewise, when you receive payment from a customer, the revenue is recorded on the date received.
Advantages
The cash method is the most simplified method of recording transactions. It is similar to how someone might track their personal expenses. You do not record payables or invoices but rather revenue and expenses are recorded as the cash moves in and out of your bank account. If you are a service business who pays bills promptly then it is a convenient method with minimal bookkeeping needed. This method can help you monitor your cash flow as it more closely relates to the actual funds in your bank account.
Disadvantages
While simple, the cash method has some drawbacks. Because it is dependent on the flow of cash it may give you an inaccurate picture if you have customers who delay payment or bills that you do not pay timely. Cash method accounting does not match the revenue generated with the expenses required to produce that revenue. You may spend a considerable sum of money on a specific project one month and not receive payment from your customer until the following month. In the first month your expenses are high while your income seems low, but in the second month your income appears high while your expenses, recorded the month before, seem low. In either month you may have a false sense of where your business stands.
What is the Accrual Method?
Accrual basis accounting records your activity as it happens. Under this method bills are recorded as they are received from your vendors and revenue is recorded as you invoice your customers.
Advantages
The accrual method follows what is known as the matching principle. The matching principle requires that expenses and revenue be recorded within the same time frame in which they relate to each other. This involves using Accounts Receivable to invoice your customers as well as using Accounts Payable to record bills that you receive from vendors. This allows you to match the expenses to the same period in which the revenue was earned. This method gives a clearer picture of your financial position.
Disadvantages
While providing a clearer picture, the accrual method is also more time consuming and complicated to maintain than the cash method. True accrual method accounting does not only record receivables and payables but also requires that you record transactions such as deposits from customers, prepaid expenses, payroll accruals, and others. These transactions also need to be monitored and adjusted when they become revenue and expenses for the period. Business owners will also need to be careful that they do not equate the income shown on their financials with the amount of cash they have available to spend.
The Prius (Hybrid) Method
Okay, the Prius method is not an official name for a method of accounting, but a hybrid method which combines some aspects of both the cash and accrual methods is frequently used. While not appropriate for tax filings or issuing financials under Generally Accepted Financial Principles (GAAP) the hybrid method may prove useful for internal management. Under this method a business might record income on a cash basis while using accrual basis for payables (expenses) and payroll activity. Another business might track and record customer deposits on an accrual basis while tracking other activity on a cash basis.
Choosing the Best Option for Your Business
Many accounting software programs, like Intuit’s QuickBooks products, offer the option to flip from cash to accrual within the same set of books. Keep in mind, however, that the software is only as good as the input. If certain procedures are not used at data entry it can circumvent the software’s ability to convert between the methods properly. Likewise, a hybrid method may bypass some of the embedded protocols for conversion.
Business owners should also consider using supplemental reports to broaden their financial view. For example, an accrual set of financials gives solid information for matching revenue and expenses and can be used in conjunction with cash flow summaries and projections to complete the picture.
When determining what option is best for your business be sure to consider any regulatory requirements that might apply, your business goals and bookkeeping resources, and always talk with your accounting professional before making changes.
