Accrual accounting is one of the two most prominent accounting methods (the other being cash basis accounting). The accrual accounting method gives better insight into a company’s business operations from a financial perspective. It looks at revenue and expenses in tandem at the times that they are generated.
Smaller businesses may benefit more from cash basis accounting. This is a simpler alternative that keeps bookkeeping clean and manageable for small operations. Larger businesses, however, can benefit more from the accrual accounting method.
In this post, we will give an overview of how the accrual method works and how businesses can benefit from implementing it.
What Is the Accrual Accounting Method?
The accrual accounting method is a combination of two key accounting principles. The first is the matching principle, and the second is the revenue recognition principle.
Matching refers to recognizing expenses at the time that you make purchases, even on credit. Revenue recognition refers to recognizing revenue at the time that the business earns it, meaning when the business delivers what it gets paid for and not when the business actually gets paid.
In the same way, the accrual accounting method notes expenses when the business is liable for them instead of when the business pays them.
In accrual accounting, you clarify how revenue and expenses relate to each other. This gives you a greater and more accurate understanding of your profitability alongside your business assets and liabilities. Because of this, the General Accepted Accounting Principles (GAAP) accept only accrual accounting. (Note that the Securities and Exchange Commission (SEC) also requires it for publicly traded companies.)
How Is Accrual Accounting Calculated?
You can calculate profit and loss on an accrual basis by looking at the direct correlation between your business income and expenses. This way, the record shows the numbers using balance sheet accounts. These can be accounts receivable, accounts payable, prepaid assets, and accrued expenses.
First, you calculate all the business’ earned revenue. Remember that earned revenue in accrual accounting is anything that has been invoiced, even if it’s unpaid. As long as you have delivered the requested goods or services, that is considered income earned.
Second, you calculate all the business’ incurred expenses. Remember that you incur expenses as soon as you request goods or services for your business. It doesn’t matter if cash has actually been released or not. If you have the invoice from the vendor, that is a recognized expense.
Third, you subtract the accrued, or accumulated, expenses from your accrued income. That number is called your net profit or loss, depending on whether you got a positive or negative result.
Because revenue and expenses are rarely always the same in a business, the accrual accounting method can show higher numbers – whether profits or losses – depending on how you manage it.
You can, for example, invoice back orders in January to enjoy lower taxable income for the previous year. In the same vein, you can choose to spend more at the end of the year to get bigger deductions from expenses, even if you won’t actually pay for these acquisitions immediately.
What Is an Example of Accrual Accounting vs Cash Accounting?
We have seen above how accrual accounting works. With cash accounting, you record income and expenses when you have the actual cash in hand or make the actual payment. For example:
Revenue: You sell a service on trade credit, payable within 30 days of delivery.
With accrual accounting, you record that revenue under credit after you perform the service, usually when you generate the invoice for it and record the transaction, but before you receive the cash. You also record it as accounts receivable under debit at the same time. Then you record it again as a cash debit and accounts receivable credit when you receive the actual payment.
With cash accounting, you simply record the revenue when you get paid for it. That payment is recorded as an increase in your cash balance.
Expense: You buy office supplies on credit.
With accrual accounting, you record that expense when you receive the supplies, under debit then under credit as accounts payable to the vendor. When you pay, you then record the accounts payable item under debit and record the amount as cash under credit.
With cash accounting, you simply record the expense when you pay for it. That payment is recorded as a decrease in your cash balance.
What Type of Businesses is Accrual For?
If you log more than $25 million a year in sales, then you must use the accrual accounting method. This is because it conforms to GAAP, so the government requires it. Sometimes, a bank will also require records that use the accrual accounting method.
Usually, any business that stocks inventory will need to use the accrual accounting method. This is because the business will most likely order product on credit. If this is you, then you know you stock inventory when you expect sales. With this method, you get to match sales with the expense of purchasing that inventory. Of course, this does not show directly when you also make sales on credit. In that case, you would not receive payment in the same accounting period. With accrual accounting, though, you can still keep the record straight because you will record revenue and expenses that match even if no cash has traded hands yet. Using a cash basis accounting system where credit is involved can make bookkeeping overly complicated.
The accrual accounting method is perfect for any business that wants to see an accurate and current picture of its financials. A cash-basis system would mean that the business could not report any sales until you receive actual cash. This would make credit purchases look like revenue failures on paper when they are actually going to be paid in a couple of weeks. Consider especially the global market and how most business operations are now on a credit basis. You will benefit from the simplicity of accruing sales and expenses when you take the complexities of delayed payment into account.
What Are the Advantages of Accrual Accounting?
The accrual accounting method will provide you with a more long-term view of your company’s financial situation. This is because you will see revenue and expenses on credit alongside those already paid. You will know all your receivables and payables at a glance, along with all the actual cash that came in and went out. Accrual accounting is therefore a more accurate picture of earnings and expenditures over a time period.
When you see a more realistic picture of income and expenses in real-time, you can also see customer buying trends and business expense trends. This helps you better prepare for future quarters and peak versus lean seasons. You can also get a better look at how you are doing quarter over quarter and year over year. Moreover, this method conforms to nationally accepted accounting standards. If you expect your business to grow, then you can benefit from getting familiar with accrual accounting as early as now.
Accrual accounting gives you a more accurate picture of your business’ financial status. You have the record of revenue as soon as you earned it, and expenses as soon as you incur them. This is a direct match between revenue and expense.
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