Timely, accurate financial information is essential to running a successful business. There are a number of accounting methods you can use to record and track your business’s financial performance. Here’s an overview of cash, tax and accrual basis accounting to help you choose a method that’s appropriate for your situation.
Cash basis
Often startups and sole proprietorships default to the cash method of accounting because it’s simple and provides an immediate picture of available funds. This may suffice for small businesses with uncomplicated financial affairs.
Under cash-basis accounting, you record transactions only when money changes hands. For example, if you buy a new computer on credit, you only record it as an expense once you pay cash for it. While this recordkeeping is easy, it can be challenging to get an accurate picture of your business’s financial situation. This method also isn’t suitable for tax purposes.
Telltale signs that a company is using cash-basis accounting can be found on the balance sheet: The company won’t report any accrual-basis items, such as accounts receivable, prepaid assets, accounts payable or deferred expenses.
Tax basis
Another financial reporting option is to use the same accounting method for book and tax purposes. Under tax-basis accounting, you only record transactions when they relate to tax.
This method can be helpful for companies that want to minimize their tax liability. It can also be beneficial if your business doesn’t have complex financial affairs and you don’t need up-to-date information about your financial situation.
Accrual basis
As your business grows and has more sophisticated financial reporting needs, you may decide to transition to the accrual method of accounting. Businesses that issue financial statements under U.S. Generally Accepted Accounting Principles (GAAP) must use accrual-basis accounting. GAAP is considered by many to be the “gold standard” in financial reporting. Most lenders and investors prefer statements prepared using this method because it’s the most reliable for long-term financial planning and decision-making purposes.
Under accrual-basis accounting, revenue is recognized when earned (regardless of when it’s received), and expenses are recognized when incurred (not necessarily when they’re paid). This methodology matches revenue to the corresponding expenses in the proper period. Compared to the cash and tax methods, the accrual method helps you more accurately evaluate growth and profit margins over time and against competitors.
Using the accrual method also can help you manage cash flow. For example, with more timely financial data, you can negotiate payment terms with suppliers, plan for significant expenses and forecast future cash needs.
What’s right for your business?
Choosing the right accounting method for your business depends on your financial needs and accounting skills. Some businesses use a hybrid approach incorporating elements from two or more methods. The method you’ve used in the past may not be appropriate for your current situation.
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