When you start a new business, you have to make a decision regarding how you will approach your financial management. Two basic methods are available to you: cash basis or accrual basis.
Cash basis is an accounting method that counts income only after cash or a check is received and expenses are not counted until they have been paid. This method is the most popular accounting method among entrepreneurs and small businesses.
Accrual basis is an accounting method that counts income when orders are placed or services are requested, regardless of payment being received. Expenses are counted when your request for good or services is fulfilled.
If your business makes less than $5 million during the fiscal year, you have a choice between the cash and accrual methods. If your business makes more than $5 million during the fiscal year, or your gross receipts exceed $1 million per year, you must follow the accrual method.
One method isn’t necessarily better than the other, but each has its unique selling points. Here are a couple items to keep in mind when choosing your accounting method:
- How you want to view and analyze cash flow – Because you don’t keep track of expenses and incomes the same way, the actual dates you put in your ledger will determine what your financial situation looks like. Do you need a more specific number to dictate your spending habits?
- What tax season will look like – Accrual accounting will set you up for a different process than cash accounting. Transactions that happen during the same fiscal year will look different between methods. You will need to take special note of transactions towards the end of one year and the beginning of the next.
- Neither method gives you the whole story about your financial situation – Depending on how you value and interpret your numbers, one method might seem more beneficial to you. However, one method does not deliver more information that the other – it all depends on how you use it.
If your business hasn’t grown to the point where you must use the accrual method, do some research before picking your how you handle your bookkeeping. Switching to the other method after making your first decision isn’t impossible, but is an extremely difficult and tedious undertaking. Talk to your accountant to get further insight about choosing your method. He or she might even have a preference as you begin your business relationship.