During my business model series earlier this year, I mentioned cash vs accrual accounting. (See The Cost of Doing Business)

Some folks reached out to me to ask about the difference between the two, so I thought I’d answer that question along with providing some additional context.

Legal Disclaimer: This is purely for informational purposes only as I am not a financial, accounting, or tax professional.

Now that we've gotten that out of the way. Let's get into it.

Generally speaking, the two methods of accounting for your business income and expenses are cash and accrual.

The difference between the two is in how (or rather when) you record the money going in and out of your business.

Cash-based Accounting

• Income and expenses are recorded when they are received or paid.
• When you issue a client an invoice, you don’t record payment until you actually receive their money. Similarly, when you order supplies and are billed by the supplier, you don’t record the expense until you actually pay the bill.

Accrual-based Accounting

• Income and expenses are recorded when they are incurred.
• When you issue a client an invoice you record the payment even though you have yet to receive a dime from them. When you order supplies, you record the expense upon receipt of the supplier's bill even though you have yet to pay a penny.

So why would you choose one over the other?

For some businesses, there really is no choice. If you’re a publicly traded company or are required to file audited financial statements, then you must use accrual accounting. If you have investors or lenders, then this may apply to you.

It may also make sense if you produce, purchase, or sell merchandise and have an inventory.

Accrual accounting provides a more complete picture of your company’s health than cash accounting because it accounts for the income you are owed and the payments that you owe in addition to those that have already passed into or out of your bank account.

As a result, accrual account is significantly more complicated than cash-based accounting, which is why many small businesses wait to employ this method until they really need to.

On the flip side, accrual accounting doesn’t give you as clear an understanding of your cash flow and how much money you actually have on hand as cash-based accounting does.

For instance, if you’ve got a lot of outstanding invoices, you may not immediately realize that your cash flow is low until you’re struggling to pay bills or make payroll.

Like with most things, there are benefits and drawbacks to each method, but there is no doubt that cash accounting is the easier of the two.

Once you pick your accounting method, here in the US, the IRS expects you to stick with it. If you want to switch accounting methods, then you must file a form and get their approval.

Before making any changes, speak with a Certified Professional Accountant (CPA) to ensure you understand any government requirements and/or limitations. And, be sure to review the impact on your taxes, financial reporting, and overall financial management of your business.

Have other questions you'd like answered or want to review a particular aspect of your business strategy?

You're in luck.

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Until next week,

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PS - If you missed it, last week I advised you to Live and Learn.

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