So your blog is making you money?
Now that you are seeing some income, it’s important to figure out what method of accounting you are going to use. There are two main accounting methods: 1) cash and 2) accrual. Basically, the methods differ in when they record sales or purchases to your accounts. This post will explain the generalities of both methods, and the pros and cons of each. An accounting professional will help you decide which is the best method to use for your business.
The Cash Method of Accounting
The most commonly used method of accounting by small businesses is the cash method, and it’s pretty straightforward. In the cash method, income is recorded when it is actually received, and expenses are recorded when they are actually paid.
For example, if your business is a service-based one, you may not be paid for your services until after they are complete. If you complete your online home design consulting service in January and invoice your client immediately, but don’t get paid by your client until February, the cash method simply dictates that you record the income from that payment in February. It works the same for expenses. If you upgrade your design software in March, but you use credit and pay it off in installments in April and May, then you would record those expenditures for the months of April and May.
This method is better about accurately depicting how much money you have in the bank. It can be misleading for business planning though, because it fails to show when the sales and purchases happened, but rather when the income or expenses occurred. So upon first glance, you may think you had a great month of sales, but really you just had a lot of clients make payments for sales over the previous months.
The Accrual Method of Accounting
The accrual method of accounting records the income or expenses when the governing transaction occurs, rather than when the money changes hands as in the cash method. So, if you are a service-based business, then you will record the income for each job when you complete the service, not when you actually receive the income. If you are purchasing something, you record the expenditure when you actually receive the purchased goods, not when you pay for them. The important part of the accrual method is determining when the transaction is completed and needs to be recorded.
Using the examples above, if you complete a home design consulting project in January, but your client doesn’t pay you until February, then under the accrual method you record the income in January. Likewise, if you upgrade your software in March, even though you aren’t finished paying for it until May, you still record the expenditure for March. The date you use to record your income or expenses is the date when the governing transaction is complete – when you’ve completed the job or received the product.
This method is better for showing you the income and expenses as they are happening, which can give you a broader picture of the trends in your business. It fails, however, to account for current cash flow and could leave you with lots of sales on the books but no money in the bank.
So, Which One Do You Choose?
You are probably free to choose either method for your small business. (You must choose the accrual method if your business sales are over $5 million a year or you have gross receipts of $1 million a year for sales of something you keep in inventory. Oh, to dream…anyway.) The main difference between each of the methods is how it will affect your taxes. More specifically, the method you choose determines the tax year in which you count income and take deductions on expenses.
Most small businesses operate on a calendar year basis for their tax year (for purposes of this article, we will assume you do too). Let’s say you complete a design project in December 2014, but don’t get paid until January 2015. Under the cash method you would claim the income from that project for the 2015 tax year, because that is when you actually received the income. But under the accrual method, you would claim the income in the 2014 tax year, because that is when the service was completed. The same idea applies to deductions. Under the cash method, you would be able to deduct business expenses only in the year you paid for them. But under the accrual method, you may deduct business expenses in the year you incurred the obligation to pay for them.
These are the general differences in the two main accounting methods for small businesses. As always, it’s important to consult with your CPA on the best method for your business.