Confused about choosing an accounting method for your business? Actually, it may seem complicated, but you are at the right place to understand how can you keep good track of your income and expenses. You can also learn the why to choose GAAP accounting over cash method. There are 2 ways to do so.
Cash– This method means the transactions are recorded only when payment is received or made
Accrual Accounting– This method records revenue and expenses when they are earned in real-time even if payments haven’t hit or left your account yet.
You might have heard about GAAP accounting or Generally Accepted Accounting Principles is not a form of accounting software but a set of widely accepted standards and rules set in place to ensure companies account for their financials in the same way. Unlike cash, Accrual is the acceptable form of accounting under GAAP’s rules.
Let’s take an example for the better understanding of differences between the methods:
“Example 1”- Kelvin is a hotdog seller. He runs his own small stall of hotdog on New Jersey’s streets. He charges $2 per hot dog. One day, his friend arrives there and wants to buy a hotdog but doesn’t have any… cash. Kelvin decides to let him buy the book now and pay later.
- Under the cash method, Kelvin is still at $0 for that hot dog and will have to wait until his friend pays him to recognize the $2.
- Under the accrual method, Johnny is $2 richer!
“Example 2”- Kelvin’s hotdog business gets very popular so he decides to open a restaurant and charges $5 a month for unlimited hotdogs. Kelvin’s friend has been saving up and wants to pay kelvin $60 for a whole year.
- Under the cash method, Kelvin has made $60 this month but will make $0 from his friend for the next 11 months
- Under the accrual, method kelvin defers that $60 into $5 across each of the 12 months of the subscription contract.
As his restaurant grows, Kelvin finds that there are people who are interested in investing in his business. His investors want to present his financials to the FOOD AUTHORITY OF USA and will ask him to make them GAAP compliant. This will be easier if he’s using the accrual method to then have Ben and Wyatt (ex-CPAs from across his block) apply the additional rules and principles GAAP accounting requires.
As you have already seen or know that cash accounting made sense when people paid cash for everything at the time of purchase. Smaller businesses early stage startups lean towards cash because it seems simpler to people who without an accounting background. But it is all good until your business grows and gets more complicated.
Implementing GAAP accounting makes your business stronger and helps you become a better entrepreneur in the process. Be aware of the things that may change as financial obligations for you and becomes more complex.
More control over income through accrual accounting than cash
Isn’t it frustrating if you have to wait to “get paid? Cash method will always leave you the mercy of the customers and vendors. It is hard to expect when each payment will be reflected in your accounts.
With accrual accounting your account for this income as you earn it instead of waiting to receive the actual funds. This forces you to see where you aren’t hitting expectations you’ve planned for and spot issues in collections and other profit centers that cash just can’t provide.
Planning is difficult with the cash method
Your accounting service is the language of your business and you need to manage it well and provide the insight into your business that no other process can. It is difficult to plan the future with cash method as until you will not receive it, you have no idea what to do further. In such case, It is easy to lose track of things like settling your accounts receivable or recognizing interest income, and these oversights can add up.
To overcome the blunders bookkeeping, you can go for accrual/GAAP accounting which helps you to record your transactions as they happen so they are visible in your reporting giving you the insight to plan your business’ next steps.
Don’t let cash method stifle your business
Anyone who starts his/her own business wants to see it growing. At first, it seems simpler and easier route. But during and after you scale, cash just doesn’t cut it. Cash cannot provide you the ability to identify future hurdles and opportunities
Choosing GAAP accounting over cash method is a better way to plan for the future and anticipate cash flow trends, almost like a crystal ball. This information is invaluable when forming a business model that’s built to last.
You are not even in the list of investors without GAAP
Company’s finance picture cannot be just provided by cash. It can’t show the costs you’ve accrued, which investors will want to know and it’s not a reporting system they are used to seeing so they usually won’t feel comfortable that they’re making an informed decision.
GAAP accounting is something a potential investor will look for as it makes it easy for them to decisively invest or trade stocks in your company even when they aren’t familiar with your business. All publicly traded companies are required by U.S. law to report their financials using GAAP accounting.
Impossible to get a loan without GAAP accounting
You cannot get a loan for your business on cash method as banks and lenders will not consider you to do that. In case you will ask for the loan from bank then it will typically ask you to go back and hire an expert to provide more accurate (“legitimate”) financials using the accrual/GAAP method.
Choosing GAAP/accrual accounting will ultimately help you have a more accurate way to predict cash flow so you can do the cash management better. You can even diagnose potential issues in your earning capabilities. IMPANIX as a team of accountants, bookkeepers, CPAs, and tax payroll specialists can help with any questions or pain points you have as it is experienced in both cash and accrual accounting, compliance with GAAP.