There are two types of accounting systems or methods available to business owners: cash accounting and accrual accounting. These two accounting methods are important to understand, because a business is required to use one or the other consistently in recordkeeping for tax purposes. Here’s a definition of each:
In the cash accounting method, debits and credits are recorded to accounts only when money actually changes hands. For example, if a business sells a product today for $100, but the customer doesn’t have to pay for it for 30 days, the business wouldn’t alter their cash account records until the money is actually received.
Benefits of Cash Accounting
1. Working under a cash accounting model can be easier for small business owners in the sense of time spent.
2. It’s easier to determine actual cash on hand, instead of just money owed to the business.
3. It’s often also easier for small business owners to understand basic cash flow, as opposed to asset and liability accounts.
In the accrual accounting method, debits and credits are recorded to accounts when the transaction itself takes place, regardless of when cash actually exchanges hands (with “cash” meaning any kind of payment for goods or services rendered). Using the same example as above, the business would alter their accounts to reflect payment once the product is sold, rather than waiting until the cash is actually received. It would be done in multiple parts however. The transaction would first be accounted for in a receivables account (money owed to the company, and an asset), and the receivables account would be decreased when the cash account was increased after the payment was actually made.
Benefits of Accrual Accounting
1. Expenses can be counted towards tax deductions even if the purchase isn’t technically paid for until the following year, as long as the transaction occurred in the tax year in question.
2. Leads to more comprehensive recordkeeping and account evaluation when looking at a company’s current financial situation (cash on hand, liabilities owed to others, cash owed to the business, etc.), which can help in determining typical collection times to make them more efficient.
Look into both the cash and accrual methods of accounting thoroughly before deciding on a model for a new business, because trying to change accounting methods down the line can prove extremely difficult.