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Understanding Cash vs Accrual Accounting: Which One is Right For You?

Both cash and accrual accounting methods have key pros and cons. It is vital to know which method best suits your business.

The need to track and report on financial performance has never been greater than it is in today's world, especially for real estate investors. Thankfully, financial reporting (although more sophisticated and more accurate than ever) is now easier than it has ever been. There are still choices to be made though, especially for smaller businesses with limited resources. Cash accounting and accrual accounting are two primary accounting methods that are used to track and report on financial performance. Each has its own benefits and disadvantages. Understanding these differences will help you understand the right way to keep track of your real estate company’s finances.

What is Accrual Accounting?

Accrual accounting is a method of accounting that records transactions when they occur, regardless of whether the money is actually received or paid. Accrual accounting works well for companies that take on debt because it allows them to record interest as it accrues. In addition, accrual accounting can help businesses avoid penalties for late payments. This happens when the buyer pays the seller before the end of their term and there's an accrual period

What is Cash Accounting?

Cash accounting is a method of tracking and reporting on financial performance by interpreting transactions in terms of the cash (currency) or other monetary values that are actually received or paid out. Transactions are recorded when they take place, and are not adjusted to reflect what would have happened if they had taken place at another time.

Cash-Based accounting is more straightforward

Cash-based accounting is more straightforward. Each transaction is automatically recorded as either a debit or credit to one of the company’s accounts. There’s no need to worry about a general ledger and it doesn't require monthly reconciliations. The only thing you have to do is track cash flow and make sure that the bank account has enough money coming in to cover expenses. If there isn’t enough cash, it should be a warning sign that something needs to change. Cash-based accounting also makes tax preparation easier because profits are taxed only when they are actually received, not when they are earned.

Accrual-Based accounting is more complicated and accurate.

Accrual-based accounting is more complicated and accurate than cash-based accounting. Accrual-based accounting tracks transactions that have taken place, but have not yet occurred. Cash-based accounting only tracks transactions when they are made. Accounting has evolved into a complex system with overlapping lines of reporting and a multitude of accounts to track.  Tracking the entire history of a financial transaction from beginning to end is critically important for accurate performance reporting. This can be done with accrual-based accounting, but not with cash-based accounting. To illustrate how this works, let’s say you purchase $500 worth of goods on credit. You will actually owe the vendor $500 when you make the purchase even though you don’t owe them anything right now. In this case, accrual-based accounting would recognize that your balance sheet should reflect an asset account called “Accounts Payable” which would track your liability account (in this case, it would be “Credit Card Payable”). Cash-based accounting wouldn’t realize this liability until you actually make the payment in cash (e.g., by paying off your credit card or writing a check).

Why use either one?

Cash accounting and accrual accounting are used for different purposes. Cash accounting is usually used when a company wants to track its day-to-day cash flow. This method works well for smaller businesses that don't have a lot of complicated transactions happening. Accrual accounting is better suited to companies with more complex financial transactions, an international presence, or a fluctuating inventory that needs to be monitored closely. Both methods are designed to give you a picture of how your company's performance over the course of one year. The difference is in how the accounts are tracked during that time period and what information is made available at the end of the year.

Which is better for your business?

Whether cash accounting or accrual accounting is better for your business depends largely on your financial situation. Cash accounting is best for those with seasonal businesses, while accrual accounting is better for those dealing with complex finances.

Cash Accounting

Advantages:

- Permits you to report on your earnings as they happen

- Helps in tax planning

- Simple and straightforward to use

Disadvantages:  

- No long-term forecasting capabilities (it only covers short-term)

- Doesn't account for expenses that haven't occurred yet (future)

Accrual Accounting

Advantages:

- Lets you measure profit over a period of time rather than just from the day it was earned

- Allows you to smooth out fluctuations in day-to-day earnings

- Helps you avoid tax liability by allowing you to defer paying taxes until another time period when the income will be recognized

Disadvantages:

- More complicated and time-intensive

- Can skew the short-term financial view of the company

At the end of the day, both accounting methods are effective, and both can be utilized through online platforms such as Quickbooks. The important thing is that you're tracking your real income when it does come in and have an effective system in place to handle your transactions. To handle rental transactions, be sure to use property management software such as Rentroom in order to receive the added benefits over other online payment processors.

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