As if accounting wasn’t vexing 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 prepare a quick summary of the differences:
The method used by many sole proprietors and small businesses (i.e. dead-simple bookkeeping).
Easy and straightforward: You record income when it’s received and expenses when they get paid (checks in = income, checks out = expenses).
- While cash accounting makes intuitive sense, the biggest drawback is that it doesn’t provide truly accurate financial reports. For example, your sales can be disproportionately high one month (if you deposit payments from many customers all at once), and your expenses can be artificially low (if you forget to enter all your bills).
More technical and time-consuming than cash accounting, but widely regarded as the more professional and correct method. Among accountants, accrual accounting is "real accounting."
Provides accurate financial reports because income and expenses are recorded when they occur and can’t be ignored or moved between periods.
Requires significantly more technical accounting skill than the cash method (for example, to correctly record income and expenses each month and to handle trickier issues on the Balance Sheet).
Which method is right for you?
If you have a small, simple, service-based business and you run things primarily by looking at your bank balance every week, then the cash method might be fine and dandy. However, if your business has any type of technical accounting whatsoever (inventory, COGS, fixed assets, accounts payable, payroll liabilities, sales tax, bank loans, etc.), or if you need accurate financial reporting on a regular basis for management purposes, then the accrual method will be required.
In many cases, small businesses start out with the cash method and then transition to accrual accounting (or a combination of the two) as they grow and their accounting needs become more sophisticated.