When you first set up your company’s accounting, you need to setup your financials under the cash or accrual accounting method. Before you begin implementing either method into your organization’s finance tracking methodology, it’s best to know how the two work. Follow along as we get down to the bottom of the difference between these two accounting methods to allow you to choose which one best fits the needs of your business.
Although cash-basis accounting provides a simplistic approach, it may misrepresent the company’s actual financial position. Bills that have been received this month but not yet paid would not show up as expenses, even though the company has incurred those costs. Similarly, revenue that was earned this month would not show up on the financial statements until the customer paid.
Because of these weaknesses, accrual accounting is built on the framework of complete transparency to match revenue and expenses to the period incurred. Accrual accounting reports income when earned vs. received and expenses when incurred; not necessarily when paid.
Looking at the accrual method from a high-level perspective, it uses standard accounts such as; cash, equity, income, and cost of goods sold (COGS) in its configuration. With the accrual method, you must record income when you have earned it and record expenses when services were rendered (or products were shipped). Even if there hasn’t been a transfer of money, it still needs to be accounted for on that exact date, making this method slightly more complex to track compared to cash basis accounting.
This is why it’s imperative that if you stay the course with accrual accounting that you keep track of any money that you owe and owed to you down to the dollar and date. For instance, when you pay rent for one year, it is crucial to come up with a monthly adjusting entry to recognize the amortization of this cost across the year. As companies grow, accrual basis is required to report to investors, management, and publicly (for exchange-listed companies). Implementing accrual accounting early on in a company’s lifecycle helps to avoid significant overhaul later when the company grows and maintains clear and accurate financials starting from inception.
Accrual is in line with Generally Accepted Accounting Principles (GAAP) requirements. If your business is looking for outside funding in the future via a small business loan or investment from an angel investor or Series A/B/C, etc. then the expectation will be that you will be using accrual accounting best practices.
Although only public companies are required to use the accrual accounting method, it’s still a show of good faith that you’re willing to be transparent with your business operations to an interested investor. While many smaller, private companies use the cash basis method for its simplicity, companies filing with the Securities and Exchange Commission (SEC) need the accrual basis for accurate reflections of their business activities and greater transparency for stakeholders.
*This blog does not constitute solicitation or provision of legal advice and does not establish an attorney-client relationship. This blog should not be used as a substitute for obtaining legal advice from an attorney licensed or authorized to practice in your jurisdiction.*