Which Accounting Method Is Best for Your Minnesota Business

Cash and accrual accounting are both valid ways of managing your business finances. What functions your business serves will let you know which method is best.

When you start a business, you're going to need to figure out what method of accounting is right for you.  There are two standard types of financial tracking, the cash method and the accrual method.  Both options have advantages and disadvantages, but it is up to you to choose which one fits your company's needs.

What is the Accrual Method of Accounting? 

The accrual method bases your income on when it's earned and expenses as they are billed.  While using this method, you are recording the clients' transactions as they arrive, rather than when they are paid.  This method will give you a better sense of where you are financially over time so you can plan expenses accordingly.  One of the downsides to this method is that this is a hypothetical budget.  This method shows what you are owed rather than exact dollars that you have in your account.

Benefits of the Accrual Method of Accounting

The accrual method looks great on paper to investors and lenders because it can make your company look very profitable.  If you are a larger business, this is typically the method you would use.  If you are a business with revenue over $25 million, this method is required by the IRS.  By logging all of your invoices as they come in, you're creating a long-term budget.  Using this method helps you recognize your revenue as it is billed.  For example, if you bill a client for $1000 in August but they don't pay you until October, your bookkeeping for August will reflect that sale rather than October.  This helps you set up a budget for potential peak months and will also help you schedule accordingly for slower months. 

Disadvantages of the Accrual Method of Accounting

However, one thing you will need to monitor is your cash flow.  While the accrual method gives you a more realistic look at your long-term funds, you don't have a clear idea of your cash flow because the physical funds are not in your bank account.  Monitoring what has been earned and what has been spent is very important to keep your bookkeeping up to date and accurate.  This method can also have an inaccurate view of your short-term budgets if you have outstanding invoices.  Since your records are showing what you are owed, it looks like you already have those funds on hand when in reality you may not receive that payment for a few months.

What is the Cash Method of Accounting?

Cash accounting is more applicable for small and medium-sized businesses.  Like accrual accounting, you are recording income and expenses, but the funds are being paid/billed in real time.  This gives you a much better idea of your cash flow and will help you log your profits and losses in a more accurate way.  For example, if you bill someone $1000 in May and they don't pay until June, you wouldn't record the payment until the month of June.  The same applies for expenses from your business as well. If you need to purchase supplies in May but don't pay until June, that expense wouldn't be recorded until June.

Benefits of the Cash Method of Accounting

Cash accounting is very simple and straightforward for small and medium-sized businesses.  Much like tracking your own personal bank account, you are tracking your finances in real time to get a better idea where you are financially.  This method is more accurate for short-term budgets.  Since this method only applies to payments received in the form of checks, cash, credit cards, or gross receipts, you rid yourself of complicated bookkeeping.  By using the cash method, you also have the potential for better income taxes.  Since you don't have to pay taxes on funds you haven't yet received, this can help save you money come tax time.  For example, if you have invoices from the end of the year that aren't paid until after the new year, you wouldn't have to pay income tax on those funds since they weren't received until the following tax period.

Disadvantages of the Cash Method of Accounting

Although cash accounting eliminates the need for accounts receivable/payable, if you have outstanding bills that need to be taken care of this may cause challenges to arise.  Since there is no record of the funds that you are receiving or bills that you are paying, it is very important to stay on top of all transactions.  It's imperative that you know the status of your business's financial health so you are able to budget accordingly.

Which method is right for your business?

Overall, accrual accounting is the more popular option.  Cash accounting is still a solid option for small businesses, as it eases the workload of complex paperwork, but if you're seeing the potential of increasing your business and bringing in more revenue, you may have to switch to accrual accounting.  This may be a difficult process but it is not impossible.  On the other hand, the accrual method has the potential to cripple a small business if you aren't careful.  If you aren't diligent about your bookkeeping, you could have a false idea of your revenue and have your account go negative.

If you're a small business with not a lot of inventory on hand, cash accounting can be a more convenient option, especially if most of your business revenue comes from cash transactions.  If you're worried about over-spending, this option may be a better fit since you will have cash in hand instead of pending payments.

Larger businesses with hundreds of employees, large amounts of inventory, and multiple LLCs would want to use the accrual method as it gives you a bigger picture of what your finances look like.  You're able to track your accounts payable/receivable, which will paint a more accurate picture of what your long-term expenses will be, how your financials are trending, and whether or not your business is expanding.

Whether you're setting up a new business or looking to change the way you handle your bookkeeping, it's best to talk to a professional who can help you make the right decision for your Business Administration Services. Admin Solutions can help you evaluate these needs by analyzing your financials, refining existing account records, and providing monthly reports to keep you up to date with your business's overall financial health. After having a quick conversation with one of our specialists, you can decide if we will be a good fit. Admin Solutions will be there with you every step of the way to make sure your needs are met.

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