Cash and Accrual Accounting – Which is right for you?
You may be surprised to learn that the language of accounting is diverse for small businesses and startups without specific reporting requirements. In a small business, Cash is King! Owners typically review their financial health and wellness based on the cash balance in their bank account and how that balance changes over time. This way of thinking works in the early stages when receivables and payables are easily managed, and operations are simple. However, as the business grows and volume increases, it becomes increasing more challenging to think about the business from a pure cash perspective. Contracts with customers can become long-term in nature, spanning multiple months and potentially years. Purchase Orders with vendors could also become longer in term as you purchase larger quantities for economic order quantity discounts. At a certain point, whether by outside influence or internal need, the books and records will need to shift to an accrual basis of accounting.
Cash accounting is a very simplistic way of recording financial activity in a business. The guide to cash accounting is relatively simple – record transactions as cash flows. Revenue is recorded when the customer pays you, either in advance of delivering your product or service, or after delivery. Expenses are recorded as you pay your vendors and employees. This can look very lumpy month over month on a profit and loss statement since there is no “matching principle” involved. Meaning, revenue is likely not being recorded at the same time as the associated costs, resulting in skewed margins and lack of visibility into the business economics. The simplicity of cash accounting make it easy to manage, but also make it difficult to gain insight into performance and profitability.
Accrual accounting is more sophisticated than cash accounting, and requires more work but provides greater understanding of business economics. Within accrual accounting, revenue is recorded when it is earned, and expenses are recorded as they are incurred. Though it sounds relatively straightforward, the functional accounting work requires more diligence and time to get right. The good news is that accrual accounting is a necessary tool to prepare GAAP Financials which are usually required by banks, investors, and other governing bodies. A small business usually reaches an inflexion point where it makes sense to transition from cash to accrual when the owner(s) want the margin clarity and better visibility on profitability or have a need for outside money to accelerate the business. Even after shifting from cash to accrual accounting, there are still dashboards and reports that provide visibility of ongoing cash flows inside the business.
Cash is King, but Profitability is the Queen.