All businesses must keep track of financial transactions and records. Choosing the best accounting method will provide an accurate overview of your organization’s expenses and profits. Let’s look at the different accounting methods and the importance of choosing the right one.
Common Types Of Accounting Methods
Accounting methods are the rules businesses must follow to keep track of their finances and include:
Businesses use cash-basis accounting to record cash, expenses, and income. Notably, the company only records income when it receives it and pays its expenses. Suppose your business has a long-term project. You cannot record the transaction before you receive payment. Similarly, you record taxable income and expenses in the year you receive the compensation or pay the expense.
The main benefit of cash-basis accounting is that it provides an overview of your business’s short-term financial situation. However, this method does not allow you to track loans, liabilities, and inventory. Also, cash-basis accounting does not accurately portray your business’s status because you cannot record unpaid transactions and expenses until you receive compensation.
Cash-basis accounting is used along with single-entry accounting. These simple accounting methods only record incoming receipts and outgoing expenses once. Finally, under IRS rules, your business must shift to the accrual method once average gross receipts for the three previous years reach $26 million.
Accrual accounting is more complex than cash-basis accounting because you must record incoming revenue and expenses – even if you have not received payment. In other words, you record expenses once the bill is received and only record income for a long-term contract when the transaction closes. In addition, accrual accounting considers accounts payable, liabilities, assets, and inventory.
The benefit of accrual accounting is that it allows you to record all incoming revenue, giving you a better understanding of your business’s profitability. This method also helps with budgeting and forecasting, making it easier for your business to seek financing from banks and investors.
Accountants typically recommend using a double-entry accounting system when performing accrual accounting because each transaction is classified as a debit and credit to different accounts, making it more appropriate than single-entry accounting.
Modified Cash-Basis Accounting
Modified cash-basis accounting is a combination of cash and accrual accounting. Using this method, you record all transactions and payments related to income and expenses once they occur. This method allows businesses to record short- and long-term transactions and use a mix of cash, liabilities, assets, and accounts payable. Like accrual accounting, you should use this method along with double-entry accounting.
Why Using the Right Accounting Method Matters
Choosing the right accounting method is essential for determining the financial health of your business. Some give a snapshot of your business’s short-term profitability; others provide a long-term overview of its finances.
Moreover, using the appropriate accounting method can improve your chances when seeking financing from investors and financial institutions. Finally, the right accounting method will simplify forecasting the future growth of your business.
In sum, cash-basis accounting is best suited for small businesses that need a straightforward way to measure income and expenses, even though revenue will not appear on the ledger until the payment is received.
For larger, more complex businesses, accrual accounting provides a better understanding of revenue, regardless of whether the company is paid periodically, based on the percentage of work performed, or until the project is completed. Lenders and investors may view accrual accounting more favorably because it gives a better overview of long-term revenue.
Finally, modified cash-basis accounting provides businesses with an overview of short-term cash transactions and long-term financial transactions related to their business.
Each accounting method comes with pros and cons. By consulting an experienced CPA, you can choose one that provides a clear understanding of your business’s financial health.