Keeping accurate financial records is absolutely essential to the sound running of any business. No business will survive if its accounting records are inaccurate or its transactions are not recorded in a timely manner. With the plethora of accounting software available, anyone with some basic computer skills and a rudimentary understanding of bookkeeping can get their business up and running. But what accounting method should you choose? We’ve outlined the key differences between cash and accrual accounting.
A cash accounting system is suitable for start-ups and sole traders. It’s perfect for a service business such as a consultant or contractor where there are no employees or little in the way of inventory to manage. The business provides the service and receives payment usually within fourteen days. Any expenses incurred are paid for either at point of sales or within a short time frame. Any bookkeeping required is firmly simple and straight-forward.
While this system is relatively easy to maintain, it does not provide an accurate picture of the overall health of the business. By not recording transactions in the time period in which they were incurred, both income and expenses can be artificially inflated or decreased. For example, a consultant may work on a project over a period of a month, and receive payment for the whole project in the first week of the following month. The accounts would show no income for a month then a jump in income in the following month. The same thing happens with expenses, with no way in the accounting system to even out the peaks and troughs. While it has its problems, the cash accounting system is perfectly adequate for some business owners to manage their cash flow and fulfil their tax obligations.
Accrual accounting, on the other hand, requires all transactions to be brought to account in the time frame in which they were incurred. This means that income that is technically earned is recorded even though the payment may not have been received, and expenses incurred but not yet paid for are also recorded. Control is maintained through a series of ledger accounts, and inventory is recorded as individual movements in and out of stock, rather than at the time it is purchased. As a result, the reports generated from an accrual accounting system reflect the true position of the business at a given point in time. It allows for accurate comparisons of particular time frames, and gives a timely representation of the profitability, or otherwise, of the business.
While a cash accounting system is suitable for sole traders and start-ups, as a business grows and its needs become more complex, it will become necessary change to the accrual accounting system. This system can manage employee records, large quantities of inventory, accounts receivable, accounts payable and provide the up-to-date information needed to make management decisions. If you have any questions about the best system to use for your business, just get in touch.