If you’re a small business owner today, knowing what type of accounting method to use might have been the last item on your check-list before you opened doors to your business. However, what we are about to cover is the reason you want to take a good look at your books and your own accounting practices you have in place. Recording your business transactions can be a tricky business, especially when growth starts to occurr and the complexity of financial transactions increase.
Generally speaking, businesses that have a $5 million dollar in sale average can choose whatever method of accounting they desire. However, if your busines stocks inventory to sell publicly, for instance, the IRS requires your business to use the accrual method. It’s important to understand how the way you are doing business can impact your IRS reporting and compliance. We strongly recommend you consult with an accountant or outsourcing group for a more accurate assessment.
An accrual system of accounting, where it is strong for reporting business income and debts more accurately, can also leave a weak financial picture of what cash reserves are available. For instance, your income ledger may show thousands of dollars in sales, while in reality your bank account is empty because your customers haven’t paid you yet.
At the same time, although a cash accounting system can give you a better picture of your cash reserves, it may not report the most accurate financial picture of longer term profitability of a company. For instance, your books may show one month to be spectacularly profitable, when actually sales have been slow and, by coincidence, a lot of credit customers paid their bills in that month.
Why would a business switch to accrual methods?
Making a switch from cash basis to accrual may not be easy for some. It may mean bringing in experienced, outside help to assist with the transition or verify changes for accuracy. However, there are 5 simple reasons experts say accrual could be right for you:
1. Improving your Financial Picture
“Accrual accounting easily allows the business owner to see at a glance if the company is profitable, where the profit is coming from, and where expenses are going. Accrual accounting also matches revenues with the expenses the company incurred to produce it.”
2. Staying GAAP Compliant
In the United States, GAAP (generally accepted accounting principles) is considered the industry standard for preparing financial statements. In fact, companies in the United States with $5 million dollars in annual sales or $1 million dollars in annual inventory sales are legally required to use the accrual accounting method as part of GAAP in order to report their financial information and for income tax preparation. Meeting GAAP allows a company’s financial picture to be easily accessed by investors and other financial institutions.
3. Improving Accuracy
Accrual accounting gives companies a truer depiction of their resources and financial responsibilities. This serves as a company advantage because according to Inc.com, it allows businesses to properly manage the ebb and flow of financial activity. Income and debts can be more accurately assessed with accrual accounting.
4. Planning for growth
Cash accounting is an “after the fact” accounting style, while accrual accounting is done in real time. According to World Bank, accrual accounting makes it easy for business managers to plan the future. Since they do not have to wait for cash to be received to see what their profits are, professionals can strategize ways to improve sales or generate more revenue as they spot financial plateaus. This keeps a company progressive, which is crucial to viability.
5. Obtaining Credit
In order to expand, or even to survive, most businesses will depend on credit. Accrual accounting allows companies to record and measure credit – both credit owing as well as owed.
Examples of Cash Accounting vs Accrual Accounting Methods
For a more in depth and “real world” example, we found an article that explained it the best. Inc.com details for us an explantion and example of what we mean by comparing the cash accounting vs accrual accounting methods.
The most significant way your business is affected by the accounting method you choose involves the tax year in which income and particular expense items will be counted. For instance, if you incur expenses in the 1999 tax year but don’t pay them until the 2000 tax year, you won’t be able to claim them in 1999 if you use the cash method. But as you should now understand, you would be able to claim them if you use the accrual method, since the very essence of that system is to record transactions when they occur, not when money actually changes hands.
Zara runs a small flower shop called ZuZu’s Petals. On December 22, 1999, Zara buys new lighting equipment for her shop for which she will be billed $400. She installs the lighting equipment that day, but according to the terms of the purchase doesn’t pay for it for 30 days. Under her accrual system of accounting, she counts the $400 expense during the December 1999 accounting period, even though she didn’t actually write the check until January of the next year. This means that Zara can deduct the $400 from her taxable income of 1999.
Scott and Lisa operate A Stitch in Hide, a leather repair shop. They’re hired to repair an antique leather couch, and they finish their job on December 15, 1999. They bill the customer for $750, which they receive on January 20, 2000. Since they use the accrual method of accounting, Scott and Lisa count the $750 income in December 1999, because that’s when they earned the money by finishing the job. This income must be reported in their 1999 tax return even though they don’t receive the money that year.
Small business owners are tasked with having to specialize in many areas of their business. Accounting is not an area you want to let run too long without qualified eyes on your books. There are many cases of well intended business owners that let their books get out of hand and how it impacted their businesses. If you need help understanding your books, we would love to visit with you to know where your concerns are and some friendly advice.