As if accounting wasn’t perplexing enough, every business also has to choose between two different methods of keeping their books: cash accounting or accrual accounting.
Since these two terms tend to cause confusion and headaches among non-accountants, we decided to put together a quick overview of each method and explain the differences in plain English:
The accounting method used by most freelancers, sole proprietors, and small businesses with basic needs.
Cash accounting is easy and straightforward: You record sales when payments are received from customers (cash in), and expenses when they get paid (cash out).
While cash accounting is relatively easy and makes intuitive sense, the biggest drawback is that it doesn’t provide accurate financial reporting. For example, your P&L can be way off if you deposit payments from customers in the wrong month or if you forget to enter all your expenses (oops!). And let’s face it: Without a good P&L, it’s hard to know how your business is truly performing — you’re basically guessing.
More technical and time-consuming than cash accounting, but widely regarded as the more correct method. Among accountants and CPAs, accrual accounting is "real accounting.”
Provides accurate financial reports because income and expenses are recorded when they occur and cannot be overlooked or moved between periods.
Accrual accounting involves lots of rules and requires significantly more knowledge and experience than the cash method. It’s the standard accounting method if you want to generate a correct P&L each month and if you need to deal with Balance Sheet issues like inventory, A/R and A/P, fixed assets and depreciation, loans, tax liabilities, and many other things.
Which method is right for you?
That depends. If you have a small, service-based business with basic accounting needs and you run things primarily by keeping an eye on your bank balance, then the cash method might be fine and dandy. It’s simple and non-technical and gets the job done.
However, if your business has any accounting complexity at all (including the types of Balance Sheet issues we mentioned above), then the accrual method will be needed. Furthermore, if you're the type of owner who wants to see accurate financials that tell you what's really happening with the business each month, then accrual accounting is the only way to get there.
In some cases, small businesses start out with the cash method and then transition to accrual accounting — or a hybrid of the two — as their accounting needs become more sophisticated. The move from cash to accrual accounting involves some nuances and technical issues that we can’t explain here, but an experienced accountant can guide you in the right direction.