As a business owner, you would already know the importance of accurate financial accounting for better finance management. Since accounting is most likely not your area of expertise, you might usually face multiple challenges while managing your daily business chores and finances simultaneously. However, if your budget doesn’t allow you to hire a team of full-time accountants, you may choose outsourced accounting services as a strategic way to manage accounting efficiently.
Whether you do it in-house or outsource the same, know that the process starts with fundamental accounting methods – cash accounting and accrual accounting. It is mandatory to use one method for financial accounting purposes.
To help you learn more and better understand both, let’s discuss them in brief below.
What is the Cash Accounting method?
This method allows you to recognize revenues once cash is received and expenses when they are actually paid. In addition, as transactions are not recorded by the time the cash is debited or credited, your business’s income will not be taxed until it is in the bank.
Top Advantages of Cash Accounting
- Easy-to-Understand: Cash basis accounting is simpler and easier to understand than other accounting methods.
- Helps Understand Cash Flow: The cash accounting method is best to understand the cash flow in your business accounts, giving you a precise and clear picture of the amount of cash available.
- Single-Entry System: You may rely on the cash method when you are not familiar with a complex accounting system. It follows a simple single-entry system, including one entry per transaction.
Disadvantages of Cash Accounting
- Error Risks: As you follow the single-entry system under this method, you are not verifying if those entries are correct or not, increasing the chances of errors.
- Incorrect Forecasting: The cash method will not show income that has not been received but invoiced. This will give you insights for short-term plans but insufficient information to have a long-term financial forecast.
- Limited Usage: According to the IRS, if your business is a corporation, maintains inventory, or has gross receipts accounting for more than $5 million a year, you cannot use the cash accounting method.
What is the Accrual Accounting method?
This method allows you to record revenues and expenses when they are earned (after submitting an assignment or receiving a product), even if they are actually received or paid. For instance, you would record income when you complete a project, even if you have got paid in advance.
Top Advantages of Accrual Accounting
- Offers Useful Insights: This method allows you to use detailed information on your income and expenses to conduct various helpful analyses. Since you can perform multiple analyses, you can get multiple insights required to make better business decisions.
- Helps Make Financial Planning Easier: With accrual accounting, it becomes easier to plan your finances and utilize them better as it gives you complete information on your expenses and revenue with a specified period. In addition, it allows you to predict sales and prepare suitable budgets for future expenses – all essential to effectively manage inventory, staff, and other critical operational areas.
- GAAP Compliant: This method makes financial statements tell more about your business’s financial health. If you are plan to grow your business and involve external investors, accrual accounting makes your business accounting comply with GAAP.
Disadvantages of Accrual Accounting
- Complications: One big drawback of this method is the level of difficulty involved, as there are complicated rules you need to follow to recognize revenue and expenses. So here, if you want your firm to be fully compliant with GAAP, you may need accounting support to follow this method.
- Deceptions: Using the accrual accounting method, you might experience confusions that might be difficult to clear without the help of an accounting professional, leading to the deception of financial information in hand.
- Challenging to Adopt: If you are following any other accounting method, you might find it challenging to embrace the accrual basis accounting.
Cash Accounting Vs Accrual Accounting : Which one is right for your business?
Although cash basis accounting can be easier to follow, it restricts you from exploring the predictive side of business finance management. Similarly, mandated under GAAP, the accrual accounting method can be an excellent approach to get a deeper look into financials, enabling you to see your business’s economic reality but can be challenging for you to utilize effectively.
Since both have pros and cons, as a business owner, you need to consider some significant factors linked to your needs for financial information, which can also help you choose one method suitable for your business. Let’s discuss them.
- Business Type and Industry: If your industry is cash-based, for instance, you’re running a hospitality business and mostly managing cash, you can use cash accounting. Whereas, if you are managing inventory, you are required to submit accrual-based financial reports of your firm to the IRS. A similar example is C corporations generating more than 10 million US dollars, and S corporations generating more than 20 million US dollars in average gross revenue must follow accrual accounting.
- Your Need for Insights: You know you must track your firm’s bottom line to be aware of its overall health. So if you are happy to have some basic information about your business finances, cash accounting is good to go. But if you need in-depth insights to make critical decisions, accrual accounting is the best method for you.
- Reporting Requirements: If you have the basic knowledge of cash flow and mostly manage cash, cash-based financial statements might be sufficient for you. But if you want to adopt auditing practices and seek external investors, you will need accrual-based financial statements.
- Future Plans: For example, if you are currently using cash-basis accounting and have plans to grow or expand your business in the future, you would need to move to accrual-based financial accounting.
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Summary
Considering all the points discussed above, it is likely that you would use accrual-based accounting for your business, and why not if you are getting all the valuable information you need to take your business toward success.
However, if you are not familiar with the method, using it would not make enough sense. That’s where we can be of great help to you. At Cogneesol, we have been serving businesses across industries with high-quality finance amd accounting services since 2008. Backed up with 100s of skilled and regularly-trained accounting professionals, we help our clients increase accounting efficiency, improve transparency, streamline workflow, and optimize the overall financial accounting process.
So if you are planning to move to accrual-based accounting, know that we’d be delighted to assist. To learn more about our accounting outsourcing services, get in touch with us today. Send your questions to info@cogneesol.com or call us at +1 646 688 2821.
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