Business owners face an important decision when it comes to choosing their accounting method: cash or accrual? Each of these methods comes with different advantages and disadvantages, meaning one might appeal to you over the other. However, accounting methods can be changed, making it essential that you understand the basic components of each to make the right decision now and in the future.
What is Cash Accounting?
Cash accounting runs based on when cash is received. When cash is deposited or withdrawn from your bank account is when you record the transaction. For example, when you receive a deposit from a customer, the amount isn't recorded until it hits your bank account.
The CRA requires that you must report any income in the year it is received and deduct all expenses in the year you pay them. Post-dated checks and deposits won't be recognized until they hit your bank accountant.
Reporting on the cash method of accounting is easier for sole traders since they report all income and loss on their individual returns on a cash basis. In addition, this method doesn't require the use of accruals and receivables, making it simple to complete regular bookkeeping.
What is Accrual Accounting?
Accrual accounting remains the more popular method of accounting due to added transparency into the financial health of your business. Unlike cash accounting, accrual accounting recognizes income and expense items when contractual obligations are satisfied. For example, if you complete a job for a customer, but are waiting on payment, you will record the income even though you haven't received the cash yet.
This creates the need for both accrual and receivable accounts. Having these accounts on your balance sheet gives a clearer picture of where your business's financials fall and can help plan for business decisions; however, there is a greater recordkeeping burden to keep track of all outstanding items.
How to Choose the Right One?
Choosing the right method for your business can be a tricky decision. First, you want to look at your business size. Are you a small business that doesn't plan on growing? If so, the cash method of accounting might suit your business operations. On the contrary, if you are trying to expand your business and revenue, consider utilizing the accrual method of accounting to gain transparency into your accounting information.
Another consideration is the requirements of third parties. Sometimes, investors and lenders require financial statements on an accrual basis. If this is the case for your business, you would want to convert your operations to an accrual basis. Keep in mind the requirements of the CRA as well. Large businesses are required to report on an accrual basis to stay in compliance.
The cash versus accrual method has been long debated on which one is best for business owners; however, the final decision depends on your business needs. Many business owners make more informed decisions when they consult with an expert that can guide them on the advantages and disadvantages their business will incur. To talk to a team member, reach out to schedule a consultation.
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