If you are a small business owner, chances are you know how to make big decisions. Being a business owner requires that you make hard choices repeatedly, such as which accounting method you will use. Small business accounting is unlike big business accounting in that you can choose between a cash basis and the accrual method. Both methods have their pros and cons which will be discussed presently.
The Accrual Basis Method
For companies that make over 25 million dollars over three years, the accrual basis must be used under the law. However, for small business owners, they can choose. This method records all expenses and income when they are incurred, instead of when they are paid. For example, if you had a large order from a client in February, but you weren't paid until March, your books would reflect all of your hard work in February.
For future planning, it is very easy to see when your company's overall performance, since you will know when you need to increase staff to cover orders, and which months were slower. Instead of having to remember what happened, your records will reflect it accurately.
You may end up paying more in taxes since taxes are incurred when the order is placed, and not when you are paid. This can be dangerous around tax season, since you may be taxed for orders you have not yet been paid for. In addition, this method can be a little more time-intensive, since all expenses and income must be documented right as it happens.
The Cash Basis Method
On the other hand, the cash basis method records your company's work when you are paid for it. Instead of having to put all of your invoices into your accounting software, most small businesses simply wait until they are paid to document.
This method tracks your cash flow, which will be good to know in the coming years. You will be able to see when your business was flourishing and which months were tight.
It can be challenging, however, to not see when the actual work was performed, since you will only see when you were paid.
In conclusion, if you are a small business that sometimes has cash flow issues, you may want to stick with the cash basis method. It is also crucial to take rigorous notes as a business owner so that you can know what to expect for the next year. Since the cash basis method reflects when you were paid instead of when you did the actual work your personal notes could help you to have a more accurate picture of workflow.