Let’s talk cash flow. As a small business, cash flow is EVERYTHING. It’s a good indicator of your business’s current financial health, it informs your decision-making, and, through cash flow forecasting, it helps you plan for the future.
When it comes to managing and planning against cash flow, there are two main methods to consider: cash basis accounting and accrual basis accounting. How do you know which is the right one for your business? Let’s go through the basics of cash vs accrual accounting.
First, cash basis accounting.
Cash accounting is simple. You get cash in, you take cash out. The benefits are equally transparent: You immediately see how paying your bills affects your P&L, you immediately record the expense, and you know when things are getting paid for and when they’re not.
For new businesses, this style of accounting makes the most sense. Remember you don’t have to pay taxes on your income until it has been received, and you always know exactly where your money is. You can do cash accounting internally, or you might outsource to a bookkeeper as the need arises. But the bottom line is: You’re only making decisions based on money that’s in the bank.
Sounds great, right? It is. So why would anyone move to accrual accounting? There are a few reasons…
Accrual basis accounting can give small businesses a better idea of their success.
What is accrual? It’s the exact opposite of cash. Instead of recording the money when it comes in and when it goes out, accrual records money when it is earned, and when it is incurred. It’s all about timing. How does this affect your business? By helping people who are worried about expenses, depreciation, and more, when they’re making important revenue decisions.
When is it necessary for your business to use accrual accounting?
- Your company sales total more than $5 million.
- The IRS requires that you keep an inventory of merchandise for your customer (we call this an audit requirement).
- You are required to by a bank or shareholder.
When is it advisable for your business to use accrual accounting?
- You sell services over a 1-2 year period but get paid upfront.
- You need the information to make better business decisions.
- You want to start accepting non-cash entries.
When any of these situations apply to you, it’s time to consider how you will transition from cash to accrual because it’s necessary for helping your business move forward. Why? Because you know that your clients will pay 30 days from now. So why wait to start reinvesting that profit?
Here’s how you can make the transition from cash to accrual.
The big difference in the actual process of cash versus accrual accounting is how it’s managed. Once you step into accrual mode, you need upper-level management that understands the complexity of accrual. This means you need more than a bookkeeper.
At the very least, you need to add a controller team for your accrual accounts. This doesn’t mean you fire the bookkeeper (that job is still important!), but it does mean you need additional services.
By adding a controller to your team, even if it’s just outsourcing a virtual controller, you can get expertise in making judgments based on the additional layers of complexity. A controller will be able to implement procedures like deferred revenue, accounts payable, accounts receivable, and more. It’s not just a technology update, it’s a manual update — one that is unique to your business expenses and future goals. (Aren’t sure that you’re ready for a controller? Here’s how to find out whether it’s the right move for you).
The best part: You don’t actually have to make a total transition. In fact, many people choose to employ a hybrid of cash and accrual accounting. The benefits of this are clear: make big financial decisions with the accrual method, simplify some parts of your tax payments with the cash method.
So, which of these three are right for you?
We always recommend starting at the very basic (i.e. the cash method) and only adding complexity if your business is required to use or could largely benefit from using certain accruals. For most people that means cash basis except for credit cards, accounts payable, and accounts receivable. If you want to get more complex than that make sure that you’re partnering with someone who truly understands the infrastructure that is required is to get you organized and working toward the next level of growth.
Want to have a conversation with an expert about which method is right for your business? Reach out — we’re happy to be the sounding board that you need.