Starting a business comes with a long to-do list. One of these decisions to make early on is keeping track of financial transactions for your company.
As a business owner, you have the choice between two methods when it comes to recording financial transactions in your business – cash basis or accrual accounting. The main difference between these methods boils down to timing – when do you record the transactions in your bookkeeping system?
The cash basis method requires you to record revenue and expenses when money has changed hands. On the other hand, the accrual method requires you to register income when you make a sale or receive an invoice for expenses, even if you haven’t collected payment.
The choice you make will help you manage the financial health of your business and fulfill any reporting obligations you might have for the company.
The cash basis is a simple way of recording transactions, which can be ideal for smaller businesses. If using the cash basis system, you would:
- record income only when your customers paid you for the work done or the goods you sold
- deduct expenses only when you are paid for them, not when you invoice them.
Cash Basis is simple.
The upside of the cash basis system of accounting is that it is much simpler than accrual accounting. The income is only entered into the bookkeeping system when you receive the money, not when you do the work or deliver your products. Likewise, you can only record any expenses when you pay for them, not when you get an invoice or receive the services. This accounting system lines up with the cash flow of a business. Therefore, net income will always be equal to the cash in hand or at the bank. Therefore, there is no need to keep track of accounts payable or accounts receivable for accounting purposes.
Cash Basis takes a short-term view.
While the cash basis is a simple system, it has several downsides.
- Inaccurate financial picture: The cash basis system of accounting can paint a picture of a profitable business when there is lots of cash on hand but not enough profit. Or the company may look like it has poor financial health even when income is high because the business is not flush with cash.
- Short-term focus – The cash basis system provides only a short-term view of the business. For example, when you have an influx of payments or receipts, your business will look healthy, while when you are waiting to receive payments, your business may look like it is in poor financial condition.
- May need to change it when you grow – Larger and public companies use accrual accounting. If the business gets to that stage, you may have to change it in the future anyway.
- Not fit for tax compliance – For most businesses, the CRA requires accrual accounting. Only a few types of companies are allowed to maintain a cash basis for tax purposes. You may find that your business needs two sets of books if you want to keep a cash basis system.
The accrual basis of accounting is a more widely used system as compared to the cash basis. If using accrual accounting, you would:
- record income when you earn it, even if you have not received payment
- deduct expenses when you incur them, even if you have not paid for them yet.
When money eventually changes hands, you will record a separate transaction in your bookkeeping system. Under the accrual system, accounts receivable and accounts payable are tracked separately for accounting purposes.
Accrual Accounting is widely accepted.
Most large businesses use accrual accounting. Accrual accounting is a more complex system, but it comes with plenty of upsides.
- An accurate view of the business – The accrual system of accounting tends to smooth out earnings. As a result, it provides a better idea of how much profit your business generated, even before receiving the money.
- Grows with your business – Most larger companies and public companies use accrual accounting. However, if your business ambitions are to grow, you may have to change your bookkeeping to accrual accounting later in the business’s life.
- Fits with Tax and Accounting Requirements – For most businesses, the CRA requires accrual accounting. Only a few types of companies can maintain their books on a cash basis for tax purposes.
Accrual accounting is more complex.
The downside of accrual accounting stems from its complexity.
- More work – More work may be involved in maintaining the books as you record more frequent transactions. Your business may need additional help to keep up.
- Not reflective of the cash balance – The accrual system does not reflect your bank balances. A profitable company can have very little cash, and a company flushed with money may be unprofitable.
How to choose the correct method for your business?
The choice that you make for bookkeeping systems can have an impact on your business’s financial health. The cash basis of accounting is more straightforward and would require less work to maintain. It is also easier to understand because it reflects the cash in your business. The accrual accounting system is more complex and requires more time and expertise to reflect your business accurately. But it can give a more accurate view of the business. The system that you choose can help you manage the financial health of your business and fulfill any reporting obligations you might have for the company.
Consider who is using the information: If you have investors or are looking to get funding from the bank, their preferred system can help guide your decisions.
Resource and Support resources: Accrual accounting requires more expertise. You can outsource your bookkeeping and reporting tasks to professionals to help ease the administrative burden.
Contact Edelkoort Smethurst CPAs LLP in Burlington to understand the best accounting system for your business.
The accounting or tax professionals at Edelkoort Smethurst CPAs LLP can help you set up your business’ accounting system right from the start or help you as you grow your business. To learn more about how we can assist you, please contact us online or by telephone at 905-517-2297