Starting or running a business is an exciting adventure that brings with it a host of tasks, like keeping track of the financial health of your organization. There is more than one approach to financial management, so choosing the right basis of accounting for your organization is crucial to gain an accurate picture of financial trends and make projections for your business. The method of accounting you decide on can also impact when your assets are fluid. Whether you use an accountant or track income and expenses yourself, choose only one method of accounting and stick to it for consistency and accuracy.
Basis of Accounting
The two types of accounting that most businesses use are the accrual-basis and cash-basis method. Some businesses use the modified cash-basis method, which combines principles from both the accrual- and cash-basis methods.
While each method of accounting records assets, liabilities and equity, they differ on when each is recorded, thus impacting the financial snapshot of a business at any given point.
The three primary components of the basic accounting formula (which must balance at all times) are as follows:
- Assets: Assets refer to tangible and intangible assets of a business, such as cash, land, inventory, buildings, accounts receivable, investments and other financially viable items. Assets equal liabilities plus equity.
- Liabilities: Liabilities refer to the financial obligations of a business to pay its creditors for accounts payable, accrued wages and loans.
- Equity: Owner's equity or shareholders equity refers to the profits available. Equity plus liabilities equal assets.
Accrual Method of Accounting
The accrual method of accounting reports revenues on the income statement when they are earned and matches related expenses when the expense occurs, not when the bills are paid. Accrual accounting results in an income statement that provides an accurate representation of the profitability of your business for a specific period. For example, if a sales representative makes a large sale on December 15 but does not expect to receive payment until January 15 of the next calendar year, the accrual method records the sale as revenue in December.
Likewise, if a big project requires ordering materials this month, the accrual method of accounting records the invoice as an expense, rather than waiting until its paid. This method helps keep track of money you need to reserve to pay the invoice. It also helps to avoid mistakes where you accidentally purchase something with money already designated for another purpose.
If expenses are incurred due to incoming revenue, like supplies needed to install furniture a customer ordered, these expenses are matched and recorded with the revenue instead of listed separately, giving a reasonably accurate picture of what capital will be available following completion of the project. This is handy because it keeps both assets and liabilities from becoming inflated, which can happen when they are recorded separately. It also makes tracking profit margins simple and fast because income and expenses for the same project are tracked together.
While maintaining a broad and long-term perspective on finances is helpful in business accounting, the accrual method is not without its disadvantages. Accrual accounting requires more estimation and guesswork than cash accounting, which only deals with revenue and expenses as they occur. For instance, it is possible to count income before it is actually in your bank account and then spend it, sending a new business into the red or even bankruptcy.
The accrual method also takes more time and is best overseen by a professional accountant who knows the ins and outs of how to use the accrual method of accounting accurately. One sticky area of accounting that is best left to the professionals is estimating bad debt or income that is not likely to come through. While your business probably has mostly reliable clients who pay their bills promptly, there will be those who pay their bills late or not at all. A professional accountant knows how to estimate these losses to give you a relatively accurate picture of your business's financial health.
Cash Basis of Accounting
The cash basis of accounting records revenue when money is received and expenses when they are paid. For instance, imagine your business purchases 75 units of conduit for an upcoming construction project, but the invoice does not arrive until a month after you receive the goods. Your bank account is a bit slim, and so you wait another week to pay the invoice after it is received. You do not record the expense until that time, even though your business may have already placed the conduit in the construction project. For a small business, it can feel like a relief to not have to record an expense until it is paid, but it can also cause you to accidentally overspend your budget and end up unable to pay money you owe to a creditor promptly.
The same principles apply to revenue. For example, you sign a contract with a new client who agrees to pay your business several thousand dollars upon completion of a major project, which will take you a couple of months to complete. In the meantime, your business must purchase materials and complete the work, which is an expense. Using the cash basis of accounting, you only have the funds that are currently in your bank account available to purchase supplies. While you won't accidentally go into the red with the bank, you will have an inflated picture of the expenses now and an inflated picture of your income in two months when the project is complete. This makes any record of cash available to your business inaccurate and unreliable.
While the cash-basis method of accounting is not as accurate as the accrual basis in the long haul, one advantage is that it does not require as much wiggle room as the accrual basis. The estimation required by the accrual basis is most safely used by a business that is profitable, with enough financial leverage to cover expenses before income is received. Your business may start with the cash-basis method of accounting and then, with the help of a professional accountant, move to the accrual basis as your equity increases.
Modified Cash Basis of Accounting
The modified cash basis of accounting combines the strengths of both the accrual and the cash basis of accounting. In this method, income is documented as it is earned, using the accrual method. At the same time, expenses are documented when they are paid, as in the cash method of accounting. Although the modified cash-basis method does not adhere to generally accepted accounting principles or GAAP, some business owners believe that it brings together the best of both major methods of accounting.
For example, if you contract to build a house in October that will be finished in January, the revenue is recorded in October. The building supplies that are purchased toward completion of the project are recorded gradually throughout the project. In this way, your business maintains an accurate record of income and sales, while having the flexibility to keep assets fluid as long as possible during the building process itself. Consequently, the modified cash basis of accounting can be helpful for some small businesses who have big projects coming in, without the large bank account to match.
The most significant disadvantage of the modified cash-basis method of accounting is when an outside agent or auditor examines your business's financial records. Because this method does not conform to GAAP, you will have to go back and convert all your records to either the cash-basis method or accrual-basis method of accounting. This excess work would cost your organization time and money in the long-term.
- CPA Journal: A Look at the Modified Cash Basis
- Singhad Engineering Institutes: Accounting Concepts
- Financial Accounting Foundation: About GAAP
- American Institute of CPAs: Preserving the Cash Basis Method of Accounting for CPA Firms
- Accounting Tools: Basic Accounting Formula
- Accounting Tools: The Cash Basis of Accounting
- Accounting Tools: The Accrual Basis of Accounting