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 among non-accountants, we decided to put together a quick overview of each.
The method used by many sole proprietors and small businesses with dead 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 reports. For example, your P&L can be waaay off if you deposit payments from customers in the wrong month or if you don’t enter all your bills.
More technical and time-consuming than cash accounting, but widely regarded as the more correct method. Among accountants, 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.
Requires significantly more experience and skill than the cash method (for example, to correctly record income and expenses each month and to handle trickier accounting issues like interest, depreciation, and tax liabilities).
Which method is right for you?
If you have a small, service-based business with a low volume of transactions and you run things primarily by looking at your bank balance a few times a month, then the cash method might be fine and dandy.
However, if your business has any type of accounting complexity (such as inventory, COGS, significant A/R and A/P balances, sales and payroll taxes, fixed assets and depreciation, etc.), then the accrual method will be needed. Furthermore, if you're the type of owner who wants accurate 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.