When most entrepreneurs start their new venture, they naturally use what's called cash basis accounting. This is the simplest way to keep track of your income and expenses. But at some point, as the business grows, most business owners switch to a method known as accrual basis accounting. What does this change mean? And why might your small business benefit from it? Here's what you need to know.
How Is Accrual Different From Cash?
The primary difference between these two methods for keeping books is when you record income and expenses. Cash accounting records transactions when they occur. If you purchase new inventory on December 1, you record the expense that day. Then, if you sell that inventory on January 1, the income is recorded in the new year.
Accrual accounting attempts to keep the recording of income and expenses consistent with when the company uses or benefits from them. If the inventory bought on December 1 won't be put on sale until January, the purchase is accrued (moved forward) into the new year. Then, when you sell those goods, the expenses match the timing of when you benefit from the sale of them.
Why Would You Switch?
Accrual accounting is, as it might appear, more complex than using the cash method. So why go to the extra effort? First, it more accurately reflects your real business operations. Under cash accounting, that inventory transaction would be a large expense in one year but the sale in the new year would have no corresponding expense. Both years are inaccurate.
This inaccuracy between when money flows and when the business benefits from it means that cash basis financial statements may diverge wildly from month to month. Lenders, for instance, may not approve you if they see what appear to be large fluctuations and inconsistencies in your financial stability.
Finally, IRS rules require that most businesses use accrual accounting once they surpass $25 million in gross receipts over three years. Companies also generally must use accrual accounting if they go public. Even if your business is far from these goals, it may behoove you to switch now rather than later.
Where Can You Learn More?
Could now be a good time to make your company's financial statements accurate, get real-time information on its profitability, and prepare for future growth? If so, start by learning more about accrual and cash accounting by consulting with an accountant in your state today. With their guidance, you can make the right decision for your organization and bolster it for many more years.
For more information on accounting, contact a professional near you.