- Learn about the two most popular business accounting methods.
- Find out how to choose the best method for your business.
- Learn about hybrid accounting.
Every small business – whether a respected local mom-and-pop retailer, a startup tech company or an online venture — has accounting and bookkeeping responsibilities. These include selecting the accounting method that works best for them. If you’re new to small business ownership, you might not even realize that there are multiple ways to keep tabs on your company’s finances.
Don’t worry, though, that’s where Fiducial’s guide comes in! As you keep reading, you’ll learn more about two common business accounting methods. You will also find helpful advice for choosing the right one for your business.
What are the most popular business accounting methods?
The two most popular business accounting methods are the cash method and the accrual method. As with anything, there are pros and cons to both tactics. Let’s take a look at what distinguishes each of them. How do you determine the best fit for your company’s needs?
First, you need to understand that each accounting method is a way to track your incoming and outgoing money.
Fundamentally, the biggest difference between these two accounting methods is whether you track revenues and expenses when they are actually in (or out) of hand or when they are billed. There are many factors you’ll need to consider before choosing a method for your small business. Evaluating the following will help you:
- The size of your business
- Your business’s future growth projections
- Whether you are a sole proprietor or a corporation/publicly-traded company
- Whether you have (or plan to have) investors involved in your business
Most sole proprietors and small businesses have the freedom to choose the accounting method that they feel most comfortable with. However, companies that have investors will likely need to use the method that their investors want them to use based on a vote.
Also worth noting: Publicly traded companies earning more than $25 million in gross revenue per year must use the accrual accounting method.
Two Methods for Accounting
With that understanding, let’s take a closer look at the two accounting methods.
- Cash Method
The cash method records revenue on the date that the business receives payment for goods or services. It records expenses on the date that they pay an invoice for goods or services. This is the easiest way to keep track of cash flow. Business owners using this method can skip steps such as journal entries. They may also wait to pay taxes on revenue until they actually receive payment. This method is ideal for freelancers and contractors, especially if clients are slow to pay. It also works well for new business owners, who are just learning the ins and outs of bookkeeping.
- Accrual Method
The accrual method records revenue at the time that a service or product is sold – not when it is paid. This accounting option subsequently expenses on the billing day of a transaction rather than on the day of payment. This provides business owners with a high-level sense of their balance sheet. It also allows business finance specialists to be proactive in how they pay their bills to maximize cash flow. This method is more complicated. However, most accounting professionals prefer it because it provides a true sense of a business’s financial health.
Businesses that use the accrual method of accounting have the disadvantage of having to pay taxes on sales that may not have been paid, so it is essential that business owners or their accountants know the status of all incoming cash and accounts receivables. Even with this downside, accrual accounting is typically the right method for growing businesses that are looking to expand, hire additional employees, or are seeking financing or investors.
- Hybrid accounting
represents a combination of the two accounting methods listed above. It is most appropriately used by businesses that stock inventory, as it allows them to track the cash coming in and going out of the business for products or services on a cash basis – but to track inventory using the accrual method. Though this combination of accounting methods offers significant advantages, it is a complicated approach that requires assistance from an experienced bookkeeper, either in-house or from a reputable third-party financial institution.
No matter which small business bookkeeping method you eventually choose, it is important that you take a thoughtful approach to make your selection. Whichever technique you choose will be the one that you are required to stick with for at least one year. You are not permitted to switch accounting methods midstream, though you can adjust in a new tax year.