When setting up a new business you are faced with a wide variety of decisions. One such decision is how you will be keeping your books. Deciding if you should keep a cash accounting system, or an accrual accounting system depends a great deal on what type of business you run. In order to choose the best method, you must take into consideration the current size of your business, your plans for the future, and if third parties (such as shareholders, or lenders) will be involved.
This being said, you may still be left wondering which system is right for you. For the most part, the accrual accounting method is the main foundation of GAAP (Generally Accepted Account Principles) and is the most commonly used accounted method by businesses of all sorts and sizes. Businesses that do not have any employees and those that do not deal with inventory typically prefer a cash based system.
Cash Accrual Accounting
Many people believe that a cash based accounting system is much easier to manage because every business transaction in or out of the company is recorded in a ledger, which is quite similar in design to a chequebook register. Every expense is recorded, and every bit of income that is actually received is recorded. As a general rule of thumb, this method is acceptable for any business that is not a corporation, that does not carry any inventory, and whose average gross income is not more than five million dollars.
Accrual systems, on the other hand, record income that is technically earned, but may not have actually been received. It also records expenses that were incurred whether or not they have actually been paid. This method of accounting is a much better choice for any business that is a corporation or one that projects several million dollars in annual income. Accrual accounting may also be a good option for any smaller company that intends to seek funding from a financial institution, shareholders, or other types of external financing medium. These types of transactions are typically required to be audited by an independent accountant; therefore an accrual system is mandatory in order to produce the necessary GAAP financial statements.
Deciding on Cash or Accrual Accounting
Even businesses that are suitable to use a cash based accounting system may want to consider setting up their books to use the accrual method. This is because a cash system causes the value of long term assets and liabilities to carry over without identifying their benefit to future terms using depreciation and amortisation. Businesses using a cash system must then keep separate ledgers to track all “non-cash” items such as fixed asset depreciation, receivables, and payables. Perhaps the biggest difference in the two accounting methods has to do with inventory reporting.
When a business uses a cash based method, the whole expense of purchasing inventory is recorded at one time, which may be months or even years away from when a sale is made to produce income. Because this time may be so far away, it is difficult to accurately match the income with the actual cost of the goods sold. This makes it hard for the business to determine if the sale actually resulted in a profit or a loss.
Growth and the Future
While establishing a cash based accounting system is certainly better than not having any type of bookkeeping system, it is not the best option for a growing company. It is always best to establish a system that will allow you to fully track all of your resources in order to present a clear picture of how well the business is performing on the whole.
When it comes to exploring the advantages of using Accrual based Accounting or Cash based accounting methods, give Books Onsite a call today on 1300 2BOOKS and we can discuss all your business bookkeeping needs in simple terms which will allow you to fully explore your options.