It’s reported that more than half of small businesses fail within the first five years. What many small business owners fail to take into account when starting their businesses are their payment terms. These are the conditions in which payments are to be expected and the conditions on the payments. Many small businesses use a cash basis of accounting as their terms of payment because it’s easy to use and understand.
However, this could be the deciding factor on whether your small business will flourish or crumble. Instead, an accrual basis of accounting will allow small businesses to get a better understanding of their finances to make more accurate financial decisions. Here’s why switching to accrual basis accounting can help your company succeed.
What is Cash Accounting
There’s a lot to be said about cash vs. accrual accounting. Cash accounting is simple. It’s pretty much how you do your own personal finances—when cash comes in and cash goes out. For example, when you go to the farmer’s market, you’ll bring your debit card (thank you chip readers!), visit the different vendors, and stumble upon something you want to buy, let’s say lettuce.
You go to the cashier, she charges you $2, and your debit card balance of $100 is now $98. The same works for businesses who use cash accounting—they recognize their revenue and expenses in real-time, so they know how much money is at hand.
However, using a cash basis of accounting is extremely difficult for businesses who take credit, receive invoices, or have an inventory. For example, if you own a bakery, you will typically order all of your ingredients and supplies at the beginning of the month.
With a cash basis of accounting, the price for inventory will be deducted immediately. However, doing so won’t give you (the owner) enough information for when and how orders should be made. And, it won’t give you insight on how your bakery inventory stacks up to your revenue.
Because of this, a cash basis of accounting can give you inaccurate representations of your company, making you think you have more money than anticipated, which can lead you to make harmful decisions such as hiring a new employee when you really can’t afford to. Having a financial advisor is one way to ensure you don’t make any rash decisions like these with your company’s finances.
What is Accrual Accounting
On the other hand, accrual accounting tracks transactions as they are billed and earned. The difference between cash and accrual accounting is a matter of when. So, if you use an accrual basis of accounting, you won’t take into account whether the money has been deposited or not.
Rather, you’ll look at these transactions as they will happen. This process is similar to an IOU. Before the days of CashApp, you’d lend your friend some money, they’d let you know they’ll pay you back, and you’d anticipate the money coming at a later date.
Why is this important? Because it’ll give you an accurate reading for how your business is performing in the long run. This will allow you to budget, grow your business, and handle your business finances responsibly.
Why You Should Switch
If you own a business that doesn’t have an inventory or you have a sole proprietorship with a few employees, cash accounting should work for you. However, most businesses should switch to accrual accounting in order to meet generally accepted accounting principles (GAAP) set by the Securities and Exchange Commission.
These standards set the common ways of reporting and recording accounting information. This is important for small businesses for a variety of reasons, including:
- Trying to secure government contracts: Getting a bid for a government contract can turn your small business into the next big success story. However, the only way to get there is if you have accurate accounting records. Before a government agency decides to choose you, they will go through your financial records to ensure you’re a trustworthy candidate. This means being compliant with GAAP standards and using accounting best practices.
- Taking your company up a notch: If your company is rapidly growing, switching to an accrual basis of accounting will get you there. The GAAP accounting principles suggest that companies making over $1 million should convert to this style of accounting in order to have more accurate bookkeeping.
The Bottom Line
An accrual basis of accounting isn’t the easiest form of accounting. However, it will give you a more accurate understanding of how your business is performing compared to a cash basis of accounting.
To help, you can always use online bookkeeping software to manage all of your transactions, as well as cloud-based services to store all of your receipts as well.