If you’re using the wrong accounting method for your business, it could cause some big problems with your accounts, profits, and taxes.
Now, bear with us, because we’re going to get a little technical here when it comes to accounting terminology. Don’t despair – we’ll keep it simple – but as a business owner, it’s your responsibility to understand these and make a decision that is best for your particular business.
There are two main business accounting methods: cash and accrual.
The Cash Accounting Method
Cash accounting is the simpler method – and the one that most small businesses choose upon start up – because it’s based on the actual flow of cash in and out of a business. Even as businesses grow, the cash method is still used by sole proprietors, and businesses who don’t have an inventory.
Using this method, all the transactions that occur for your business are recorded at the time the cash actually changes hands – so, when you receive payment from a customer, or when the money leaves your bank for purchases you have made. “Cash”, as most business owners know, does not just mean dollar bills, but checks, credit card charges, electronic bank transfers, Paypal, or some other means used to pay for an item.
You would not use cash-based accounting if you’re selling items on store credit: that means the customer is paying later, so the money is recorded as coming in later. The same is true for the purchases you make on behalf of the business: you only record supplies or goods (even if you are later selling them) when the money actually is paid out. If you have a credit account with a supplier, and the payment is made later, you record it when the payment is made.
If this is the system you use, it probably makes perfect sense. A customer comes into your auto repair shop and needs four new tires. You fit them, he hands over a debit card (or a wad of cash), you record it in your little book or on your computer, and the job is done. (Even if he uses a credit card, you’re still receiving the money right then.) And if you phone up the tire company to buy more tires, and they send the tires out the next day but you don’t pay until the end of the month, you record that payment on the end of the month. Simple.
The Accrual Accounting Method
The other method – accrual accounting – simply disregards the actual exchange of cash, and records income and expenses at the time that they happen.
This means, using our example above, if your customer comes in to buy the tires but has a credit account with you, and receives a statement at the end of the month which he pays then, you still record that transaction as happening the day he came into the store. It’s recorded when the service or purchase happened, not when the cash changes hands.
The concept of accrual accounting might not sound too complicated, but this is definitely where you need an accountant. You’ll want to monitor cash flow on a weekly or monthly basis, making sure that what’s in your bank account at the end of the month is enough to cover everything you’ve agreed to pay. You’ll also want to track what customers owe you, and how to get that money on time.
Usually, as your business grows and becomes more complex, you will switch to accrual accounting because it’s easier to match revenue to expenses. Otherwise, you might think that your business is looking super profitable in a month with a few expenses, and then two months later when big expenses come in you are suddenly in a loss situation. You want to know the difference so you can plan for your business’ future.
Are you using the right accounting method?
Businesses who use the wrong accounting method can find themselves in a challenging position. If you are using the wrong accounting method for your business, you can:
– Have a false understanding of the true business position
– Find yourself easily confused about how much cash you can take out of the business
– Misunderstand the difference between ‘cash’ and ‘profit’
– Cause yourself or someone else in your business to have to spend hours and hours on bookkeeping to fix mistakes that were made
– Owe more tax than you thought
– Pay more tax than is actually due
– Spend so much time on accounts and bookkeeping that your business suffers
– …and many other problems.
Which accounting method should you use?
Here are a few quick notes on which accounting method you might use.
- Are you a new business start up? Use the cash method.
- Is your income less than $5 million? You are free to adopt either method, but you should probably talk to your accountant.
- Do you have inventory? Use the accrual method.
- Is your revenue $5 million or more? Use the accrual method.
Please note these are not hard-and-fast rules – just general guidelines. You should always talk to your accountant before making a change of this kind.
Talk to us if you’re not sure!