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Cash Method Vs Accrual Method

cash-method-vs-accrual-method

Starting and running a business means becoming familiar with, if not mastering several different fields of study. Accounting is one of the most important. You must track your business’s expenses and income using either the accrual method or the cash method, both of which are widely used and respected. The cash method reports income and expenses when they actually occur.  You do not record income until the business receives a check; likewise, you do not record expenses until you actually pay them. The accrual method records income and expenses when the business makes any income and when any expense incurs, regardless of cash flow.

Problems with Each Method

You must use the accrual method if your business makes more than $5 million per year in sales. Additionally, you must use the accrual method if your business acquires inventory that will sell to the public that will bring in more than $1 million in gross revenues. Whichever method you use, both give an only partial view of your business. The accrual method more accurately displays the flow of expenses and income, but it makes the actual cash reserves available opaque, which could lead to a serious cash flow problem. The books may show plenty of money in sales, but your bank account is empty because none of the customers has paid you yet.

How to Choose Which Method to Use

The cash method reverses this problem. It keeps track of the actual cash reserves excellently, but it shows an incomplete and potentially downright misleading picture of profitability. Cash flow in one month may be positive simply because many customers paid that month while total sales volume has slowed. Tax considerations often influence which method a business chooses. You may claim tax deductions under the accrual method for one year but not under the cash method. The key question you have to answer is current cash flow versus expected profits.

 

Resources

[1] Pakroo, Peri, and Marcia Stewart. The small business start-up kit. 6th ed. Berkeley: Nolo, 2010. Print.

[2] Siciliano, Gene. Finance for the non-financial manager. New York: McGraw-Hill, 2003. Print.

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