Entrepreneurs and small company owners can more easily analyze key metrics, cash flow, and business insights if they have a solid understanding of accounting principles and finances. When you want to expand your business or need venture capitalists to back you up, it becomes crucial to have a solid understanding of how certain accounting methods work and impact your finances. This will help you make informed decisions, build a strong financial foundation, and achieve long-term success.
If you are having difficulty keeping tabs on your business’s finances—budget forecasting, profit and loss statements, cash flow analysis, and strategic tax planning—you should consult a renowned accounting firm like CPA in Colorado Springs, CO.
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Two Most Commonly Used Accounting Methods:
In layman’s terms, accounting methods are designated frameworks used to record, analyze, and report the financial transactions of a small business or organization. They help any business accurately identify its financial position and economic worth at a given time. Primarily, there are two commonly used methods: Cash and Accrual Accounting.
Cash Accounting
The process of recording revenue and expenses when cash is received or paid by the entity—a business or organization—is referred to as cash accounting, also known as cash-basis accounting. This type of accounting is straightforward, providing an accurate representation of your cash flow while tracking the actual money. It is used by most local businesses. When handling accounts digitally, the amount written on the invoice will not be recorded in the books until you have paid it. Likewise, the amount mentioned on an invoice sent to a customer will not be recorded in the written records until you have received the payment.
This method gives you a clear picture of how much money you have at any given time in your account. However, it does not show you the amount of money you owe to others or how much is owed to you. This method has its limitations; it fails to account for long-term financial liabilities, providing an incomplete snapshot of your business’s financial condition. This is why cash accounting does not work well for large inventory businesses or big corporations. It’s less accurate, and the financial statements can be affected by delayed transactions.
Accrual Accounting
Accrual accounting is the complete opposite of cash accounting. In this method, you record expenses when sales occur and invoices are sent or received. Accrual accounting provides an accurate statement, including the amounts the other party owes to you and the amounts you owe to them. It offers a more comprehensive view of your financials. You record expenses and revenue when they are incurred, which helps your business estimate profitability and losses, predict future cash flow, and gain a broader perspective on your company’s financial health.
This type of accounting method may seem straightforward, but in reality, it is more complicated than cash accounting. It suits businesses that operate on service models, such as software solution companies, marketing firms, architects, and medical professionals. When a business starts to expand and grow its annual number of contracts, resulting in large amounts of money, those companies should rely on the accrual method of accounting. Managing large amounts of money and their flow for future contracts is much more difficult with cash accounting.
Moreover, accrual accounting helps businesses stay compliant with GAAP (Generally Accepted Accounting Principles). Moreover, compliance with the GAAP-defined standards is essential if you are seeking business lenders, investors, or other stakeholders.
The choice of which accounting method to use depends entirely on the nature and size of your business. You may need professional help when it comes to numbers, as financial churning isn’t what most business owners enjoy doing. Therefore, you should seek assistance from someone who not only enjoys it but also has in-depth knowledge of both accounting methods and your business.