Which Accounting Methods For Small Businesses Should I Be Using?
Starting a small business can be a daunting task, considering many of your initial decisions can have long-lasting consequences for the viability and success of your new enterprise. In addition to having a potentially profitable product or service, you must address a multitude of other issues before hitting the market. One such issue is which accounting methods for small businesses to chose. Making the best choice for your business requires an understanding of the relative strengths and weaknesses of cash and accrual accounting systems and you should consider the nature and size of your operation, the regulatory environment, and the accounting resources available.
What is cash accounting?
A cash accounting system is based on cash flow. Under the cash method, revenue is recognized when payments are received from customers, and expenses are recorded when payments are made to suppliers. Cash basis accounting systems are less complex than accrual systems and are often utilized in start-ups and small businesses without a trained accountant on staff.
Is it right for my business?
The cash method may be preferable for cash based entities (i.e. payment is due at the point of sale), service companies that do not require inventory or other physical goods, and more generally, any business whose balance sheet does not have significant assets in any category other than cash. For businesses where cash flow is often a key factor in decision making, cash basis accounting makes sense.
Despite the simplicity of the cash method, most companies maintain their books on an accrual basis. In fact, for many businesses, accrual accounting is required under IRS regulations. If your company has any of the following characteristics, accrual accounting is mandatory:
- Your business is organized as a C Corporation
- Your gross revenues exceed $5 million annually
- You stock inventory for sale to the public and you have gross revenues in excess of $1 million annually
What about accrual accounting?
Even for businesses that are eligible to use the cash basis, the accrual method may be preferable because it offers greater insight into the performance and profitability of the company. Using the accrual method, revenue and expenses are recorded when transactions occur rather than when they are paid. This method allows revenues and expenses to be matched in the same period. As business volume grows and becomes more complex, accrual accounting is the most accurate way to determine how profitable the company is from month to month and to analyze business trends over time.
Ultimately, there is not one accounting method that is ideal for every business. It’s not necessarily a cash vs accrual basis accounting argument. For some, the cash method mirrors the nature and flow of operations. For many, it is a pragmatic choice as the company establishes itself in the market. Even if the business grows and evolves over time, changing to the accrual method can always be done at a later date by filing IRS Form 3115 – Change in Accounting Method. LUXA Enterprises is an outsourced accounting group offering outsourcing solutions to small and mid-size businesses in the Tulsa and surrounding areas.
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