By Deanna Parmenter
This blog is the first of four in a series talking about basic accounting concepts that I frequently get asked about. By understanding these concepts, you may be able to reduce your taxes and eliminate some of the work (and fees) done by your CPA at tax time.
You are excited about your business idea, all of the preliminary planning work is done, and pretty soon you’ll be ready to open you doors. Your CPA recommended QuickBooks for tracking your income and expenses. So here you are, late at night, trying to set up your company in QuickBooks and answer all those confusing questions the software is asking you. Sound familiar?
One of the first, and perhaps, most important decisions to make is whether your business will be run under the cash method or accrual method. Accounting rules define these two methods:
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In cash basis accounting, entries are made into Quickbooks when cash is received or paid, regardless of when the revenue was earned or the obligation to pay was made.
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In accrual method accounting, entries are made in the time period to which they relate rather than only when cash is received or paid.
For example, let’s say you received some office supplies on December 20 that you had ordered. The bill is received when the supplies arrive, but you want to leave for the holidays and plan to pay the bill when you return in January. Under the cash method, you would record the payment in January. Under the accrual method, you would record the payment in your December books but show a payment date of January. Quickbooks will automatically accrue the payment for you.
When you must use the accrual method. You must use the accrual method if:
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Your business has sales above a certain amount (currently $5 million per year), or
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Your business stocks an inventory of items that you will sell to the public and your gross receipts are over $1 million per year.
Whichever method you use, it's important to realize that either one gives you only a partial picture of the financial status of your business.
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Advantages and Disadvantages of the Accrual Method
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Advantages and Disadvantages of the Cash Method
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While the accrual method shows business income and debts more accurately, it won’t show you how much cash is available, which could result in a serious cash flow problem. For instance, your income ledger may show thousands of dollars in sales, while in reality your bank account is empty because your customers haven't paid you yet.
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And though the cash method provides a more accurate picture of how much actual cash your business has, it may give you a false impression of your longer-term profitability. Under the cash method, for instance, your books may show one month to be really profitable because a lot of credit customers paid their bills in that month even though sales were slow.
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To truly understand your business's finances, you need more than just a collection of monthly totals. You need to understand what the numbers mean and how to use them to answer specific financial questions.