Every business, including a sole proprietorship, must base its bookkeeping conventions on the money that flows into the company during a given period, or on the value of business transacted that may or may not be paid immediately. The finances of a sole proprietorship are inextricably tied up with the finances of its owner, so this accounting decision can have ramifications for money management and taxes, affecting the owner's personal finances as well as those of the business.
The decision to use the cash method of accounting ensures that the company's books will reasonably effectively reflect its cash flow situation. This is particularly important for a sole proprietorship, where cash flow shortfalls must often be supplemented using personal resources or individual credit. A sole proprietor using the accrual method of accounting should be aware of the fact that the amounts reflected in her sales records don't accurately reflect her liquid cash on hand, and she should have contingency plans for financing day to day operations.
The cash method of accounting is based on the sums that a sole proprietorship collects from customers as they are collected. These sums directly translate into revenue that is available for the sole proprietor to either withdraw from the business or retain in business accounts as operating capital. The accrual method of accounting reflects transactions that may not have been already paid. Because accrued sales may still be outstanding, these revenue amounts aren't necessarily available to a sole proprietor for an owner's draw.
Regardless of whether a sole proprietorship uses the cash or accrual method of accounting, the sales it transacts will increase its owner's equity. If the business records sales as it receives payment for each transaction, each recorded transaction represents revenue that it already has on hand. If the business records sales as they're made, the sale counts as an asset on the owner's balance sheet either as cash on hand or as accounts receivable, which will be paid down the line.
The decision of whether to use the cash or accrual method of accounting may affect the amount of a sole proprietor's tax liability during a given year, although it is unlikely to affect her tax burden long term. If she uses the cash method, she'll not be liable for taxes on transactions that occurred during the calendar year but weren't paid until after the year ended. If she uses the accrual method, her gross revenue figures include all sales, whether or not they've been paid.
