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Deciding between Cash or Accrual Based Accounting
Before you can start recording business transactions, you must decide whether to use cash basis or accrual accounting. The crucial difference between these two accounting processes is in how you record your cash transactions.
Waiting for funds with cash basis accountingWith cash basis accounting, you record all transactions in the books when cash actually changes hands, meaning when cash payment is received by the company from customers or paid out by the company for purchases or other services. Cash receipt or payment can be in the form of cash, cheque, credit card, electronic transfer, or other means used to pay for an item. Cash-basis accounting can't be used if a store sells products on store credit and bills the customer at a later date. There is no provision to record and track money due from customers at some time in the future in the cash basis accounting method. That's also true for purchases. With the cash basis accounting method, the owner only records the purchase of supplies or goods that will later be sold when he actually pays cash. If he buys goods on credit to be paid later, he doesn't record the transaction until the cash is actually paid out. Depending on the size of your business, you may want to start out with cash basis accounting. Many small businesses run by a sole proprietor or a small group of partners use cash basis accounting because it's easy. But as the business grows, the business owners find it necessary to switch to accrual accounting in order to more accurately track revenues and expenses. Cash-basis accounting does a good job of tracking cash flow, but it does a poor job of matching revenues earned with money laid out for expenses. This deficiency is a problem particularly when, as it often happens, a company buys products in one month and sells those products in the next month. For example, you buy products in June with the intent to sell and pay $1,000 cash. You don't sell the products until July, and that's when you receive cash for the sales. When you close the books at the end of June, you have to show the $1,000 expense with no revenue to offset it, meaning you have a loss that month. When you sell the products for $1,500 in July, you have a $1,500 profit. So, your monthly report for June shows a $1,000 loss, and your monthly report for July shows a $1,500 profit, when in actuality you had revenues of $500 over the two months.