When you go into business there are two accounting options, each with advantages and disadvantages. For those who haven’t got much experience with bookkeeping or accounting, the cash accounting method may appear to be the ‘norm’, but in fact the accrual accounting method offers the most accurate information to business owners and other stakeholders alike.

Under the accrual method, all those one-off or annual expenses and revenues are adjusted to give a more clearer picture of the business’s performance for the year. The ability to analyze the data and spot trends over the course of the year allows you to take corrective or preventive action as soon as any deviation or downturn is identified.

Disadvantages of the Cash Method of Accounting

The cash method can be likened to the bank statement that your financial institution issues. It tells you exact amount of revenue that you have received into your account for a certain period of time, as well as the amount of cash you have outlaid for expenses. But if your business offers credit terms to customers then you’ve technically earned income but not yet been paid for it. Likewise, on the day that you pay an annual insurance premium, you’ve paid for twelve months’ worth of coverage, which you haven’t yet utilized. Imagine if all your large annual payments were due in the same month-your financial statements would look dreadful!

If you are thinking of approaching banks and/or credit unions to borrow funds for a business expansion or asset acquisition, a profit and loss statement in the red is not going to instill the bank with confidence in your business. In this case you could find financing extremely hard to come by. However, if you prepared that same profit and loss statement under the accrual method, you might end up with a very different financial story-and one which is more reassuring for the lender.

Debtors (Accounts Receivable)

Let’s say you sell a $4,000 widget, but extend to the customer credit terms whereby they pay for the purchase by making equal installments over the following ten months. Under the cash system you’d record only $400 income in month one, another $400 income in month two, etc. Under the accrual method however, you’d record income of $4,000 in month one, with a corresponding asset called debtors or accounts receivable showing in your balance sheet. Each month as the customer makes payments the entry would be shown purely in the balance sheet with an increase to your bank balance and a decrease to your debtors balance. This method makes sense since the transaction has already occurred; the sale has been made. Your financial statements should not have to be penalized over the ten month period just because of the payment method.

In the aforementioned situation, under the accrual method you would be able to identify months that have above or below average sales. Under the cash system that income would appear to be steady over the ten month payment period, which could distort critical business decisions that need to be made about staffing and inventory levels, among other issues.

Prepaid Insurance

Most insurance providers add a surcharge to customers who wish to pay for their insurance coverage month-by-month. If cash flow allows, it is usually cheaper to pay for the full year of coverage up-front. In doing so, you end up paying a large expense once throughout the year, instead of smaller amounts over time as you ‘use up’ the coverage. Under the cash accounting method, the month in which you make payment would display a large expense while other months would not show any insurance expense at all. To even this out, especially since you are entitled to cancel your policy at any time and receive a refund of the unused portion (less administrative fees), you could adopt the accrual method of accounting in your business and in this case you would record only one month’s worth of the policy’s cost in each month, with the remainder of the amount paid being shown as “Prepaid Insurance” in the balance sheet.

As you can see, using the accrual accounting method gives a clearer picture of how the business is performing overall, rather than simply what has been deposited to or withdrawn from your bank account. In this vein, banks and other stakeholders will feel much more comfortable that they have the entire picture if they are presented with financial statements prepared under the accrual method. And the support, or lack thereof, of the bank to fund your investment in an expansion to your business could completely change the direction of your future.

Sushil Kumar, CPA specializes in providing accounting and tax services to small business owners and professional practices in Queens, NY. For more information, go here: http://www.bestcpasolutions.com

Sushil Kumar, CPA specializes in providing accounting and tax services to small business owners and professional practices in Queens, NY. For more information, go here: http://www.bestcpasolutions.com

Author Bio: Sushil Kumar, CPA specializes in providing accounting and tax services to small business owners and professional practices in Queens, NY. For more information, go here: http://www.bestcpasolutions.com

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