As a business owner, it's crucial to keep a tab on your finances for projections, filing taxes, and mapping your entrepreneurial growth. This business accounting is classified into two categories: cash accounting basics and accrual accounting. These methods are classified by the differences in the timing at which they each record the revenue and expenses in the balance sheet. Let's understand the two concepts first:
This method of accounting recognizes and logs revenue and expenses only when money changes hand. For example, a company sells goods worth $5,000 in March and gets paid for them in April. Cash accounting logs in this revenue when money is credited to the organization's bank(April).
Similarly, the company buys a set of new furniture worth $3,000in June and clears its bill in July. Expenses will be recorded in July when the bank account records a debit.
Given the easy logic and math, many US sole proprietary business owners with no inventory prefer this method of accounting. Income is taxed only when actual transactions take place.
Accrual accounting logs values when money is earned (not received). It records the value when invoices for credit and debit are raised by and for the organization. In the above example, accrual accounting records revenue in March and expenses in June.
This accounting method gives a realistic view of the company's financial health and helps envision the long term more accurately than the cash accounting alternative.
While the two assets in accounting systems are diverse in their approach, let's compare their effects on the business's health and their cash flow.
Cash accounting is easy and paints the real-time health of your business's financial books, limiting its best use for short-term operations.This accounting can sometimes overestimate a company's health by declaring it cash-rich, where in reality, it may have large pending sums of account payables that exceed the revenue stream.
Accrual accounting, however, paints a much more accurate picture of your finances that helps make confident decisions for the long-run.
Consider the following scenario for an organization pitching to a set of investors:
The company has raised invoices worth $50,000 in one quarter.They're expected to be credited by the first month of the next quarter. Accrual accounting will record this value the minute the invoice is raised, which helps investors gain confidence in the company's vision.
On the other hand, only when the bank account sends a credit alert will the cash accounting method log the revenue. This situation paints a misleading picture of the company's health, thereby driving businesses away from an investment opportunity.
Also understand the meaning of double declining balance method which is used in business accounting.
Consider another scenario where a company:
The profit for April under cash accounting is recorded as:
4000 - 500 = $3,500
The profit under the accrual basis of accounting is booked for:
6000 - 1500 = $4,500 in April
Since the accounting methods record income and expenses at different times, it's important to understand the implications this has on filing taxes. For example, an organization completed its project in December2020 and raised an invoice for $25,000. They get paid in February 2021.
Since the income is received in February, it is part of your income in 2021 (cash accounting). If the income is reported in December, it comes under the income for 2020 when filing taxes (accrual accounting).
Both accounting measures have their merits and demerits, respectively. The IRS allows corporations or partnership firms with less than $5 million in sales per year to use the cash accounting system. However, businesses exceeding $25 million in gross receipts over the previous 3 years should implement the accrual accounting systems.
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