Running a business means dealing with bookkeeping and accounting. There are two ways of accounting: cash basis accounting and accrual accounting.
The main difference between accrual and cash basis accounting lies in the timing of when revenue and expenses are recognized. The cash method is a more immediate recognition of revenue and expenses while the accrual method focuses on anticipated revenue and expenses.
Cash Basis Accounting
Examples of Cash Basis Accounting
Advantages of Cash Basis Accounting
One of the major advantages of cash basis accounting is its simplicity. Keeping up with the cash flow is simple. You only count money that you have received or money that has gone out, so there is less room for mistakes. Also, cash is more flexible.
Cash is potential buying power and provides the manager with flexibility when conditions change. It may not be a profitable strategic asset for the long term, but it is an underrated risk mitigation tool for active managers in the short and medium term. As the cycle progresses further, volatility will likely pick up and the usefulness of cash as a tactical asset will likely increase.
Disadvantages of Cash Basis Accounting
Examples of Accrual Accounting
Advantages of Accrual Accounting
Disadvantages of the Accrual Accounting Method
How Both Methods Effect the Bottom Line in Accounting
- You send out an invoice for $2,000 for an advertising project.
- You receive a bill for $500 for freelance work.
- Your company paid $50 in fees for a prior bill.
- You receive $1,000 from a customer who paid an invoice from the previous month.
How to Choose the Right Method for Your Company
When choosing an accounting method for your business, pick one that works best and stick with it.
In fact, the IRS requires that you do so as stated in the accounting methods section of Publication 538:
You choose an accounting method when you file your first tax return. If you later want to change your accounting method, you must get IRS approval.
You can find out more about limitations on use of cash accounting at Cornell Law School’s Legal Information Institute.