As small businesses grow, they need to develop different accounting systems and financial infrastructure. That pile of invoices on your desk or multi-page bank statement needs to be sorted and recorded to better understand the health of your business.
Fortunately, there are a few pre-existing accounting methods you can adopt to organize your expenses and forecast future income. Cash-based accounting is one of these options, and it focuses on the current income you have on hand. Let’s take a quick look at what cash-based accounting is and how it can help your small business.
What Is Cash-Based Accounting?
Cash-based accounting only recognizes expenses and income when cash is exchanged. For example, a lawyer might provide legal services to a small business and then send the client an invoice for $150.
Instead of reporting the income immediately, the lawyer will keep the transaction off their books until the client cuts a check. Once the lawyer deposits the funds, they will then record the income.
This goes both ways: the same lawyer wouldn’t record the marketing expenses incurred to land that client until they physically pay the bill.
Cash accounting is considered useful for business owners who want to know how much they have on hand immediately and for professionals who handle their bookkeeping using existing receipts rather than forecasting their invoices.
What’s the Main Alternative to Cash-Based Accounting?
Business owners who don’t use cash-based accounting are more likely to use the accrual method, which records transactions as soon as they happen. Using the same legal example mentioned earlier, the lawyer would record the $150 fee as soon as the customer agrees to it and sends an invoice. Even though the lawyer doesn’t have that money immediately, they can predict what their income will look like in the future.
What Are the Pros of Cash-Based Accounting?
The main benefit of cash-based accounting: it’s easy. A business owner can download their bank statements and credit card transactions to see what was spent over the period—typically over the course of a month—and what was earned. This is useful for looking back over the past period and making sure everything lines up as expected.
Cash accounting also focuses on a business’s present financial situation. The business owner won’t commit to any large expenses unless there’s enough cash in the bank or credit on the card to cover the costs. This can be a good option for fiscally conservative business owners who don’t want to take on any unplanned debt.
What Are the Cons of Cash-Based Accounting?
A major drawback of cash-based accounting is that it doesn’t let business owners look ahead to the future. Think of cash-based accounting as sitting at a red light: you know where you are, and you’re focused on waiting for the light to turn green. Accrual-based accounting, meanwhile, can warn you about upcoming turns or unexpected speed bumps ahead.
Cash accounting also has the potential to overstate the health of the business. A business might take out a loan and look cash-rich but have many upcoming expenses that need to be covered. With this view, it’s hard to truly predict the financial health of a company beyond that moment.
Cash-based accounting became less popular when more business owners started taking on work based on credit instead of asking customers to pay up front. These business owners knew they had income coming in the future, and the cash-based reports didn’t accurately reflect their financial states. Accrual-based accounting may be able to help your business if you’re applying for loans or reporting your projected income and expenses to investors.
Understanding the Hybrid Model
There’s a 3rd option if you don’t know whether a cash-based or accrual-based system is right for you. Modified cash-basis accounting is considered a hybrid model between the 2. This method uses double-entry bookkeeping to record potential income and expenses as accruals.
However, the income is only added or removed to the cash section once something has been paid. This option gives business owners an idea of what their potential income looks like while still prioritizing what cash the company has on hand.
While you can develop your own unique accounting system within your business, keep in mind that it’s difficult to switch between different models once you get going. You will need to redo your books from several years past—and this could impact your taxes.
Get Your Books Sorted With Sunrise
Knowing the different types of accounting methods available can help you to clean up your books and sort your expenses in a clear and orderly way. However, you don’t need to be a bookkeeping expert to keep up with this task.
Consider hiring professionals who can take on your bookkeeping for you without ever requiring an in-person meeting. At Sunrise, we can assign a team of people to look over your receipts and invoices so you can stay on top of your finances—whether they’re cash-based or accrual-based.