There are two methods that you can choose for recording all your accounting transactions. Firstly the cash system and the other is the accrual system of accounting.
The cash system is more convenient to follow whether the accrual process is fair and logical. Thus it purely depends on the discretion of the business owner that which method is to be followed to show the profit for the period.
Determining the correct profit is very much important for a business to demonstrate the right business revenue. Several vital things like ascertaining your business income taxes, a loan or raise investments including many other business decisions depend on the same.
While implementing a particular accounting system you should be very careful. You cannot change it in a frequent interval. So ensure that you have to stick with it for a longer period.
How Cash system of accounting is different from the Accrual system?
Before selecting between Cash and Accrual Accounting system, at first, we need to understand what exactly it is.
A particular accounting method is to be needed when your business financial transactions are recorded for future purposes. There should be uniformity so a particular accounting procedure has to be followed.
- The cash method: In the cash method, recording of financial transactions are done when the actual transaction takes place. That means a record is kept when you get the cash.
- The accrual method: While on the contrary, an accrual system is a little bit different. In this method, you record the transactions not as per the date of its happening but they are recorded when they were earned or incurred.
So the core difference between both the methods of accounting system is that, cash method records the transactions when you get the cash, whereas the accrual method document the transactions on accrual basis regardless of when the cash changes hands.
Say for example you sell old furniture worth $1000 on December 15th and the customer is paying the amount on January 15th as per the mutual agreement. Here as per the cash method, the whole proceed received should be treated as the income for the month of January because of the money released in January. While on the other hand in the accrual system the income will be shown as an income for the month of December when actually the transaction took place irrespective of the cash received.
The effect on accounting here is that in the first case where the cash method is followed the transaction will be recorded in the month of January and the amount will be taxable for the next year provided the company is following the calendar year as the tax year. While in the second case the amount received will be considered for tax for the last year. This will affect the profit of the organization.
Hence you cannot simply blame any of the methods as both the methods have their own pros and cons.
A detail investigation of Advantages and Disadvantages of each method
Most importantly here you need to understand the accounting treatment for both the methods. Following different methods, you may get a slight change in the profit figure for the year. However, the difference amount will be offset in the next year.
- The Cash Method of accounting
This system of accounting is easy to record and simple to understand. It needs no specialized knowledge of the subject or expert accounting treatment. It’s like a child’s play to look at the checkbook and sales receipts and record the transaction in your income statement. Thus it can give you a clear picture of the available cash you have at any point of a given time. The disadvantage of the method is that it will not reflect actually when you earned or spent the amount.
- Accrual Method
The reason why generally people use accrual method is to smooth out the profits and losses. This is a fair and logical method. Especially when you buy or sell any item of high value, the accrual accounting system divides the transaction over several months and equalizes the profit. The downside of the method is that it fails to demonstrate the actual cash in hand so you need to maintain separate Cash flow statements to know your cash balance at any given time.
Many accounting personnel do not know which method of accounting should be selected for a particular business. Generally, small organizations find it easy to follow cash accounting because it’s easier.
We the Outsourced bookkeeping services has a team of expert bookkeeping and accounting service professionals who know how to deal with your books of accounts and which method is suitable to be used for your business. The accrual method is mandatory if your business average annual gross receipts over three years exceed $5 million. Our experienced accounting persons can tell you why outside investors need the accrual method if you are looking to raise funds.