When you enter into a business, generating revenue is usually top of mind. Equally important is how you are going to account for all that money. And it’s a decision that needs to be made early for two big reasons.
First, and maybe most obviously, not tracking finances well is a slippery slope to insolvency. Also, the Internal Revenue Service is watching.
Neither of those reasons is fun, we know, but they are important. So with that motivation in mind, let’s take a look at the pros and cons of the two main types of accounting methods.
The Right Method Matters
Choosing an accounting method is a little like getting married. Yes, you can change practices later on, but it’s not easy. Changing it requires you to file Form 3115 with the IRS. It’s a fairly complex, eight-page document that might require you to get some help from your accountant or bookkeeper.
Cash accounting is the most straightforward method. It works well for solopreneurs, some small businesses, and certain professions like doctors and lawyers. With cash accounting, you record revenue in the month it was received.
For example, let’s say you run a lawn care business. You clean two lawns in December of 2020 and bill each client $500. If they both pay you in January of 2021, you must include that income in the year it was received.
The most significant advantage of this method is its simplicity. You get a better handle of the cash available to your business while avoiding some more complex accounting rules.
But as your business grows and becomes more complex, this method can create problems. Since it doesn’t always match income and expenses in the same calendar year, results can become distorted and accounting more complicated.
Accrual Basis Accounting
Accrual basis attempts to match income and expenses in the same period. It records income and expenses when they occur, not when they are received.
Let’s say you are an attorney and billed a client $3,000 in December of 2020, but they didn’t pay until January of 2021. Under the rules for accrual basis, you would record the revenue in December 2020, the month and year you billed it.
If you rented office space in December 2020 for $500 but paid the rent in January 2021, the expense would show up in the tax year 2020.
The advantage here is a more accurate month-to-month view of income and expenses. If you used the cash accounting method, the rental expense would not match the income, giving a potentially inaccurate view at tax time. But it is much more accurate in the accrual method.
Also, banks and other lenders have more confidence in your reports because the accrual method follows the Generally Accepted Accounting Principles (GAAP). As a result, they may be more willing to extend credit.
So how do you know which one to pick?
Well, sitting down with an accountant will help. They can ask the right questions about your plans and give advice based on their years of experience. It may also be helpful to speak with other people in businesses similar to yours.
Whichever plan you choose, take your time, seek advice and choose wisely. A lot is riding on the decision!