In business accounting, there are two ways to calculate profits and losses. These are cash basis and accrual. Each method has its pros and cons, and it's wise to learn a bit about both before committing to one.
Cash basis accounting is a process where profits and losses aren't booked until money officially exchanges hands. Accrual places profits and losses on the books the minute the transactions are registered.
Imagine a T-shirt company sending products to a customer. Using a cash basis, you wouldn't register the sale on your books until the customer paid. With accrual, you would register the profit when the sale was approved by the customer.
Strengths of Each
The primary strength of cash accounting is that it's fairly simple to track. A business accountant isn't likely to use it because they understand the more complicated process of accrual. However, many sole proprietors use a cash basis when they handle their own books and taxes.
Accrual's biggest strength is that it fits nicely into tax- or business-year structures. If you make a sale in November of this year, all of the profits and costs go on this year's books and taxes. This can be advantageous in businesses where customers may take weeks or months to pay.
Tax laws also favor accruals by allowing businesses to carry losses forward. That means, if you realize more losses than you can take advantage of for this tax year, you may be able to carry the additional losses forward to next year. A startup business that only expects to be profitable several years from now can use this to reduce its tax bills once the good years arrive.
Cons of Each
Using a cash basis is generally frowned upon because it makes it harder to track when profits and losses are realized. Also, a business running a loss on a cash basis has to take the entire loss the year it happened, giving up potential long-term tax benefits.
Accrual involves a little more because it requires going back into the books to make changes when things don't unfold as planned. If a customer returns an order, for example, you have to make additional entries to make sure the losses are realized.
Which One to Use?
The answer is accrual. If you're working with a business accountant, they will almost certainly move your operation to an accrual system as soon as possible. It is widely treated as the industry standard.Share