When we are dealing with Excel spreadsheets and mountains of receipts, it's easy to forget that the purpose of accounting systems is to help owners make better business decisions. Recording transactions, preparing financial statements and analyzing data help us determine which activities are worth pursuing.
There are different ways to record transactions and keep track of business activity. One way is to record a transaction whenever cash comes in or goes out. This is known as cash accounting and it's a system used by millions of small businesses. It asks simply, “Did we spend less cash than came in this month? If so, great!” Cash-accounting systems are appropriate for the smallest businesses, with limited transactions and not much need for analysis. A single consultant working out of their home and taking on just a few short-term projects at a time is probably fine with a cash-accounting system.
If you are beyond this stage or have an interest in growing your business, then you should make the switch to an accrual-accounting system. Accrual accounting makes a better effort at matching revenues and expenses. Recording a specific transaction, like a sale, is done when you send an invoice to a client or ship out their order rather than when the cash comes in. Expenses related to the production of the good sold are also recorded at the same time the revenue is recorded, even if you pay for the expenses later. Separating the collection and disbursement of cash from the underlying transactions and matching revenues and expenses gives you better insight into the activities that take place at your company.
It's important to note that I’m talking about the accounting system that you will use for decision-making (management accounting) and not the accounting system you should use for filing your taxes (tax accounting). The drivers behind which method to use for IRS reporting are different.
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