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 often cause confusion and headaches among non-accountants, we decided to put together a quick overview of each and try to explain the differences in plain English:
The method used by most freelancers, sole proprietors, and small businesses with simple accounting needs.
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 completely off if you deposit payments from customers in the wrong month or if you forget to enter all your bills. And having a bad P&L makes it hard to see how the business is actually performing.
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 requires significantly more knowledge and experience than the cash method. It’s the standard accounting method if you want to record income and expenses correctly each month and if you need to deal with trickier Balance Sheet issues like inventory, accounts receivable, accounts payable, fixed assets and depreciation, loans, and tax liabilities.
Which method is right for you?
If you have a small, service-based business with light accounting needs and you run things primarily by looking at your bank balance a few times a month (rather than a P&L), then the cash method might be fine and dandy.
However, if your business has any type of accounting complexity at all (including all the issues we mentioned above), then the accrual method will be needed. Furthermore, if you're the type of owner who wants to see monthly financial reports that tell you what's really happening with the business, 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 they grow and their accounting needs become more sophisticated. The movement from cash to accrual accounting is part art and part science, and an experienced accountant can guide you in the right direction.