Many budding businessmen try to open up a small business being confident that their 5 to 6 years of learning period and obtaining a degree would come in handy but once they step into the shoes of an owner, they are not as comfortable and confident as they were before opening up their business. Having a business idea and the planning do not involve that much critical thinking as selecting the basis of accounting that will be used.
Before getting to the part where you decide which basis of accounting will better suit your business, we need to establish the difference between accounting transactions and accounting events.
- Accounting Events
These bring about a change in the financial statements. It causes a variation in the assets, equity or liability section of the balance sheet. Sales on credit are an example of an event but there does not need to be an immediate exchange in value.
- Accounting Transactions
These allow for transferring of value between two parties. Borrowing of money from a bank can be an example here. The exchange of value means cash is accepted in exchange of the product or service.
Cash Basis Accounting
For those businesses that have just started their operations, working on credit would not be ideal and they usually use the cash basis of accounting. This means that the expenses and revenues are recognized when cash is spent or received. Purchase on credit is not recorded until cash flows out of the business. If we consider it in terms of events and transactions, here only the transactions are of concern and not the events therefore, it contributes to poor planning.
Accrual Basis Accounting
Here, the expenses and revenues are recorded as soon as they are incurred irrespective of the collection of cash. It forms a better basis for future planning as you get to know the actual position of business concerning your cash flow. With Accrual accounting, you are aware of your true business income because events and transactions, both are recognized. Accrual accounting allows the owner of the business to account for any receivables or payables of the business.
Accrual basis of accounting is GAAP (Generally Accepted Accounting Principle). This informs you about the fact that if you are operating under cash basis of accounting then you will need to change it into accrual basis before you approach a loan officer. This is because they need to see the actual position i.e. cash flows of the business rather than just the transactions.
Cash Accounting Vs. Accrual Accounting
Although, many new business owners prefer the cash basis, maybe because it is easier but if they are truly dedicated to their business and serious about its growth, then accrual basis of accounting should be used for bookkeeping. Cash accounting is actually used just for the sake of keeping records for the business. It is also used by businesses whose transactions heavily and completely rely on cash.
Accrual basis of accounting considers transactions as well as events which results in a more accurate financial picture of the business reflecting the true position.
SK Financial in Tampa helps new businesses apply the appropriate basis of accounting and provides bookkeeping at reasonable prices to keep your business in order.