While it makes sense for most small business owners to avoid the day-to-day details of accounting, there are two concepts about the structure of their accounting records that every business owner should understand. In fact, you may have already heard the terms cash-basis and accrual-basis from your tax CPA, banker, or others. After giving a quick explanation of both, I will present three reasons it makes sense to do both and the best way to make that happen.
Cash-Basis
There are generally two ways to report on the financial performance of your business–cash or accrual. Generally speaking, cash-basis accounting counts income and expenses when they flow through your bank account. If you invoice a customer today and the customer pays you 60-days later, you would recognize the income in 60 days, not today.
There is one main reason small businesses need to keep track of their finances on a cash basis–taxes. Most start-up and small business file their taxes on a cash-basis, primarily to avoid paying taxes on uncollected receivables that, in some cases, are never collected at all. For example, if your company has $25,000 in receivables due from customers at the end of your tax year, filing your tax return on a cash-basis means you don’t have to pay taxes on that $25,000 in that tax year. With a few industry-specific exceptions, every business must switch to paying taxes on an accrual-basis once it hits a certain size, usually $5 or $10 million in annual revenues (averaged over the last three years).
Accrual-Basis
In contrast to cash-basis, accrual accounting strives to recognize revenue and expenses when they are earned/incurred, having no correlation to when they flow through your bank account. If you ship your product today and send an invoice to your customer today, you recognize the income today, even if your customer waits another 60 days to pay.
This type of accounting follows what’s called the matching principle, which tries to match all costs directly related to generating revenue to the revenue it actually generates. This means that accrual accounting is actually a more accurate way to portray the performance of your company, which is one of the two main reasons a small business should keep their records on an accrual basis. The other reason is that it is the best opportunity for you to put your best foot forward with your bank. Cash accounting usually understates performance, whereas accrual shows how you are really doing.
How to do Both
So, we have one good reason to keep the books on a cash basis and two good reasons to follow the accrual accounting principles, which means you probably should do both. But how can a small business afford to keep two sets of books when it takes so much time and resource to just do it one way now. The answer is simple–you keep your books on an accrual basis, and then your tax CPA will convert your numbers to cash basis each year when he or she does your taxes.
Conclusion
While your tax CPA may encourage you to keep your books on a cash-basis only, he or she is incentivized to give you that advice. Knowing your true performance each month and being able to put your best foot forward with outside professionals is far more important and needs to be the highest priority when you decide on the accounting basis of the financial records your keep for your business.