Bookkeeping may not be the most fun or the most glamorous aspect of entrepreneurship, but it is very much a necessary one. Newbies, and even some veterans, may feel overwhelmed and a little daunted by the prospect of beginning this task. Don’t worry, we’ve got your back. We’ve taken the time to answer some accounting method common questions to help you get started.
What are some of the different accounting methods I can use?
Accounting methods refer to how a business keeps track of its income and its expenses. There are two main types of accounting methods: cash basis and accrual. Both accounting methods are similar in that they keep track of how much money is coming in and how much money is going out. The main difference is in when the incomes and expenses are reported.
In the cash basis method, income is officially reported when the money is received. Did you sell a product or perform a service call, but still haven’t been paid for it yet? Then, no income can be written down as of yet if you are using the cash basis accounting method. You need to have the cash (or check!) in your hand before it can be considered income with this type of accounting method.
The same goes for expenses. An expense is officially incurred once the money actually leaves your bank account. For example, your business may have purchased some inventory in November, but if you don’t actually pay for it until December, it isn’t actually considered an expense and recorded until then.
On the other hand, accrual based accounting has you reporting expenses and income as they happen. For example, say you have a heating and cooling business and you install an air conditioner for a customer. Once the work has been completed, that can be officially written down as income—even if you haven’t been paid by the customer yet.
It works the same with expenses too. When it comes to expenses, you report expenses as soon as you receive a product or a service, regardless of whether or not you have actually paid for them.
Can I use both types of accounting methods?
The short answer is no. You need to choose which accounting method to use and stick with it. You cannot choose to track expenses in accrual system and income in a cash basis system or vice versa. The IRS actually states in Publication 538:
“You choose an accounting method when you file your first tax return. If you later want to change your accounting method, you must get IRS approval….You must use the same accounting method from year to year. An accounting method clearly reflects income only if all items of gross income and expenses are treated the same from year to year.”
The exception to this is the fact that some businesses are allowed to use a hybrid method of accounting that combines aspects from both cash and accrual. These are special circumstances and it needs to be approved by the IRS.
How do I choose which method to use?
The accrual accounting method is the most common, but it doesn’t mean that you have to use it. Both methods have their pros and cons. With the accrual method, it is difficult to have an accurate picture of a company’s current cash status or what cash flow looks like typically. Many companies remedy this by generating a cash flow statement in addition to the accrual accounting ledgers.
On the other hand, with cash basis accounting, it is easy to keep track of how much cash a business has, but the amount of cash in the bank doesn’t always actually reflect the status of the business. For example, a business may have a large amount of cash, but also a pile of unpaid bills. Those unpaid bills are not reflected anywhere in a cash accounting report because they haven’t been paid, but that doesn’t make them any less real.
“The wand chooses the wizard, remember….” In some cases, the accounting method chooses the business, or at least the IRS does. The IRS requires certain types of businesses to use an accrual method of accounting. According to Investopedia, the GAAP (Generally Accepted Accounting Principals) requires businesses to use accrual accounting, but only publicly traded companies need to follow the GAAP as required by the US Securities and Exchange Commission.
Despite the prevalence of the accrual method, there is still a place for cash basis accounting. Many businesses prefer it because of its simplicity.
We recommend that you consult with an accountant when determining which accounting method will work best for the needs of your business. If you still have questions, or if you would like more accounting advice, please contact us at Lucid Advisory and Finance.