- Holy Cow! I'm Not Equipped to Make These Decisions Yet!
Accrual Method or Cash Method Accounting?
It’s one of the first questions you’re usually asked when setting up your accounting software and it can be one of the most puzzling. This topic is complicated and often confuses a lot of people (you are not alone if you’re stumped). Whether it is for personal finances or business, this is an important decision that will have a big affect on your financial future.
So which is right for you? Well, that depends on your goals: are you interested in a quick fix and maintaining your financial status or would you like to get out of debt, grow your business and increase your personal financial status?
The Cash Method
The Cash Method of Accounting tracks income when it is received (money is collected) and expenses when they are actually paid (money is disbursed) in a given period. This method does not match income to expenses in a given time period. It is a strict cash in and cash out system. The benefit of the Cash Method of Accounting is that it reports a better representation of cash flow than the accrual method. The downside here is that it does not match income to the expenses that the income is associated to in the appropriate time period.
Basically, the cash method for either personal or business purposes is your absolute basic method of recording your finances to meet minimum government reporting requirements. It is a quick fix that will keep you apprised of how much you have in the bank at that moment in time. What it won’t do for you is alert you to any imminent issues like runaway debt or give you a full understanding of your financial situation. If unchecked, you could find your personal or business finances getting out of control leading you to bankruptcy and loss of your home and/or business.
The Accrual Method
The Accrual Method of Accounting reports income when earned (before the cash is received) and expenses as they occur (before the cash is paid out) in a given time period. The Accrual Method of Accounting recognizes economic events at the time the transactions occurs thus matching revenues to expense which is often referred to as “The Matching Principle”. This method’s strength is that it gives a more accurate picture of an entity’s current financial position. The downside is that it does not measure cash unless a Cash Flow Statement is included in the Financial Statement Presentation.
Accrual Method accounting takes more effort to use, and if you are self employed or own a small business you’ll definitely need a bookkeeper to help you stay on top of things, however the benefits far outweigh the expense and inconvenience. For self employed and business owners this method can alert you to growing trends of outstanding A/R that could sink you in a matter of months. It also helps you have a more accurate picture of the growth of your business. For personal purposes, this method will help you get off the treadmill of cash in/cash out and start you on a path to financial growth.
Fred’s Fast Track Tax Tip:
If you’re considering switching to the Accrual Method for your personal or business finances, be aware that there is a bit of a learning curve. I generally steer my non-public business clients to a Modified Accrual Method which integrates the Cash Method and the Accrual Method because it adds a level of reporting on the Accrual side that should be taken into consideration.
I would suggest finding an accountant in your area and scheduling a one hour consultation. Your investment in professional advice will probably cost a few hundred dollars and several hours of your personal time to understand the Accrual Method, but you will be more likely to understand it, stick with it and get better reporting results (lower debt, more savings) if you do.
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