There are 2 different accounting methods for used for businesses, the cash method and the accrual method. For some businesses you can choose either method depending on your business and your personal preference. The biggest difference is when revenue and expenses are recorded. Both methods have their pros and cons and we will discuss what makes each method different and the advantages and disadvantages of each method.
CASH METHOD
The cash method recognizes revenue only when the money changes hands or is deposited into your bank account. There is no need to track accounts receivable (which is the money owed to you) or accounts payable (which is the money you owe to others). It is easy to determine when transactions happen, gives you a better picture of cash in the bank and gives you an immediate look at your financial picture. With the cash method taxes are paid when money is received.
Advantages
* Simple to maintain
* Tracks cash
* Straightforward
Disadvantages
* Doesn’t show income that has been invoiced and not received
* Doesn’t track actual dates of sales or purchases
* Must have detailed invoicing system to track monies owed to you
ACCRUAL METHOD
The accrual method recognizes revenue when it is earned and expenses when they are billed. This is the most commonly used method as it gives a more realistic idea of income and expenses over time. This method provides a better financial picture over the long-term and accounts for money not yet received. With the accrual method taxes are paid when income is earned.
Advantages
* More accurate
* Measures performance better
* Allows for easy planning
Disadvantages
* Requires more bookkeeping
* Cash flow must be carefully monitored
* Can pay taxes on monies not yet received
If you earn less than $5 million per year, you can choose either method. Although if must keep inventory of merchandise to sell to consumers, then the accrual method is required by the IRS. It is important to review the advantages and disadvantages of each method to determine which is better for your business.