When it comes to accounting for the various transactions that your business is conducting, you have two methods - cash and accrual.
Cash method basically dictates that you account for the financial transaction when the transfer of money occurs, that is when you spend or when you’re paid.
With the accrual method, you account for the financial transaction once the promise has been made.
Let’s say your business decides to acquire a printer. You place the order in July, the printer gets shipped in August and that’s when you pay the vendor.
- According to the cash method, only when you transfer the funds to the seller will you account for it. So this transaction will get recorded in August.
- While in the accrual method, you account for the expense once you have placed the order to the seller, but still have to pay the money. So this transaction will get recorded in July.
Why use Cash Method?
Cash method of accounting, works perfectly for a business that depends on immediate payment to make sales. It also depends on the size of your business. Cash method is perfect for small businesses because it would be a financial mistake to count your eggs before they hatch. It does a superb job of closely accounting for cash flow. However, this is not the method to use if your business provides credit to customers i.e. sells a product on one day but bills on another.
Why use Accrual Method?
The accrual method gives you a more realistic view of how much money you are spending in a given period. So even if you’ve not paid a vendor yet, it is accrued for and you know you’re your expenses for the month will amount to. Accrual method can work for any kind of business but does not require you to maintain a record of the date of actual transfer (which you may need for operational processes and dispute resolutions). In such a case, you’ll have to keep a record of cash transactions as well.
Selecting on the Basis of the Fiscal Year
Let’s assume you provided a service in November, but only got paid in January, next year.
- If you opted for cash method, you’ll only be able to note down the payment after the fiscal year is over.
- However, if you opt for accrual method, then you can note the payment in November itself and it gets accounted into that financial year.
Some businesses make a choice on accrual method because of this difference.
So, there are a lot of factors that you have to take into account. Big corporations use accrual method because it suits their massive revenue and expenses, and they don’t have to worry about falling short. A small or medium sized business, on the other hand, will have to decide on cash or accrual method on the basis of their business model.