After you start operating your business, you’ll need to decide on how you’re going to account for your business activity.
And by “activity,” we mean revenue.
There are two primary methods of accounting: on a cash basis or an accrual basis. Each method has its advantages and disadvantages.
The cash method is simpler but won’t give an accurate depiction of your business’s actual economic performance. In contrast, the accrual method requires more work but demonstrates clearly your business’s profitability from month to month.
Method #1: Cash Accounting
The cash method of accounting records only the “cash events” –– like purchases and cash expenses –– that occur.
Let’s look at an example.
When you receive cash from a customer, you would record this as revenue at that time. Assume you sold 100 six-month subscriptions at $38.95 per month ($233.70 per subscription) and received the cash in the month of December. Using the cash method, you would recognize all $23,370 of this income as revenue in December when you sell the subscriptions.
Why is this important? Under the cash method, it doesn’t matter that you haven’t yet fulfilled all six months of this group’s subscriptions.
On the outgoing side, you record expenses when the cash leaves your bank account; it doesn’t matter if the cash is used to pay for an expense that covers a prior period of time.
For example, let’s say you receive a $100 utility bill in January for December’s electric services. You would record this $100 expense in January when the bill is paid and the cash leaves your bank account.
As you can see from these examples, the recording of your business activity is relatively straightforward under the cash method.
However –– and this is a big “however” –– if you want to examine the monthly profitability of your business, you would see misleading results.
- Your profit-and-loss (P&L) statements would show $23,370 in revenues in December, but $0 over the five following months.
- You would show $100 in expenses in January, despite the fact that this was for December services.
So how else might we account for this?
If you use the accrual method, your books would match the underlying economic activity with the appropriate time period.
Method #2: Accrual Accounting
In contrast, the accrual method of accounting records the revenues and expenses of a business during the period of time you earn them (revenue) or incur them (expenses).
Let’s return to the revenue example discussed above.
Assuming the December box was shipped in the same month, only $3,895 of the cash received (one-sixth of the total $23,370) would be recognized as December revenue on your P&L statement. The remaining $19,475 would be placed on your accounting balance sheet in a liability account.
As you ship monthly boxes to this group, you’ll record a journal entry for each month’s worth of revenue. After you ship the final box to these customers, you’ll have no liability left on the balance sheet and you will recognize the revenue from these customers in the appropriate month.
On the expense side, let’s look back at the example given above of the $100 utility bill you receive in January.
Under the accrual method, you would record a journal entry to show the incurrence of $100 in utility expenses in December on the P&L statement. This $100 would also display on your balance sheet as payable to the utility provider. When the cash leaves your bank account in January, you would apply that payment to the liability recorded on your balance sheet to extinguish it.
By accounting for these transactions using the accrual method, you get a better idea of how profitable your business was during December and January. The profitability of these two months is not skewed by the timing of your cash flow.
The Best Method? Consider your goals.
Based on these examples, you can see the cash method is much more straightforward –– on paper –– than the accrual method. However, investors and creditors rely on accrual financial statements when evaluating a business. This is because the accrual method better depicts the actual profitability of the business.
Questions? Start a conversation below.
This guide was collaborated on with Rylan Wirkkala, CPA. Find him in Cratejoy’s Resources for Subscription School.