Double the Fun – The 2 Types of Accounting Entrepreneurs Need To Know About
Oh the joys of small business accounting. It’s the backbone of all successful small businesses and yet it’s the one task that most small business owners dread. Unless, of course, you run an accounting firm and then I’m thinking you probably (hopefully!) like what you’re doing. But even if you have an accountant doing your taxes and bookkeeping for you, you need to understand that there are two types of accounting and which method you use can have a pretty significant impact on your business financials.
Let me start this by stating quite clearly that I’m not a Certified Public Accountant and I’m not a business lawyer, therefore, the entire focus of today’s article is to give you a basic understanding of these two different types of accounting so that should you need to, you know what questions to ask an accountant. I’m the first to say that a good accountant is worth their weight in gold and that any questions you have specific to your business needs to be directed to someone who has a much greater understanding of accounting and the tax code than I do. Ok, now that that’s clear…
Cash vs. Accrual Method
Both the Cash method of accounting (sometimes called the cash basis) and the Accrual method of accounting (sometimes called the accrual basis) deal with the recording of your revenue into the business and payments out of the business but the difference between them is the timing. Under the Cash Method, money into or out of your business is accounted for when that money actually enters or leaves your bank account. For example, if you buy a new piece of kitchen equipment on Nov. 1 and it arrives on Dec. 1, then your accounting books reflect that money going out of your account on Dec. 1. Similarly, if you make a sale to a retailer and ship them goods on Nov. 1 but, because you have Net-30 terms with them, don’t receive payment until Dec. 1, then your accounting books will reflect that money coming into your account on Dec. 1.
The Accrual method takes a different approach and records sales when they happen, even if you don’t receive the money then, and also books expenses when they actually occur, not when they were paid for. So, using the above examples again, under the Accrual Method, equipment that you bought on Nov. 1 that arrived on Dec. 1, would show the expense on your account on Dec. 1 and not Nov. 1 like under the Cash Method. For the retailer who you ship product to on Nov. 1 but don’t receive payment until Dec. 1, your accounting books would now show the money coming into your account on Nov. 1.
The reason this is important is that you can’t toggle back and forth between the two within the same year. For example, you can’t book your revenue on using the Accrual method (when you ship it out to retailers for example) and count your expenses on the Cash Basis in which you only account for those expenses when you pay for them or vice versa. That’s a big IRS no-no! In fact, once you set up your accounting system one way or another, you can’t even change from year to year without permission from the IRS.
The other reason it’s important to know the difference between the two, and this is where a good accountant can help you determine which one will be right for your business, is that the different methods could impact how much taxes you pay in one year over the next. For example, if you shipped product on Dec. 15th but didn’t get paid on it until Jan. 15th then under the Cash Basis you would pay taxes on that revenue in the new year but under the Accrual Basis you would pay taxes on that revenue in the old year. On the flip side, if you had an expense, let’s take our equipment purchase again, that you paid for on Dec. 15th but didn’t receive until Jan. 15th, that expense would be on your books for the old year under the Cash Basis and for the new year under the Accrual method of accounting.
More information about Cash vs. Accrual Accounting can be found on the IRS website here though, as always, talk to an accountant if you have questions. My apologies to non-US readers about the focus on US tax law. That being said, Cash vs. Accrual accounting is a fairly consistent model around the world though how it impacts you from a tax standpoint will be specific to the country you live in.
* Do you know where my ‘double the fun’ subject line came from? (Hint…remember those old Doublemint gum ads with the twins chewing gum (or am I just dating myself here)? )