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Accrual accounting is a method whereby revenue and expenses are recorded when a transaction is realized—regardless of whether cash has actually been exchanged.
At Padgett, we provide trustworthy and comprehensive accounting services for small businesses. We are committed to empowering our clients. In this article, you will find an overview of the most important things you need to know about accrual accounting.
Accrual accounting is a method used by businesses to record revenue and expenses when they are incurred—irrespective of when cash transactions take place. It is based on the matching principle, which holds that both revenue and expenses should be carefully matched and recorded in the same period that they occur in order to provide a more accurate reflection of a company’s financial situation. Under accrual accounting, businesses can document sales and purchases as soon as they happen.
To understand accrual accounting, it is helpful to use an example. Imagine that you operate a small advertising agency. It sends $10,000 in invoices to clients for services rendered in January. Under accrual accounting, even though those fees have not yet been collected from clients, they are reported as revenue in January. The yet-to-be-paid invoices are also reported as accounts receivable on the balance sheet. When clients pay invoices in the coming months, the payments will not be reported as revenue. Instead, they will reduce the outstanding accounts receivables shown on the balance sheet.
In January, the agency receives $8,000 in payments from clients. These payments are for invoices that were reported in revenue in prior months. So they are not reported as revenue in January; instead, $8,000 is subtracted from accounts receivables, lowering the amount reported on the balance sheet.
How are expenses reported under accrual accounting? Let’s say on February 1 the agency pays $1,000 for rent and $4,800 for insurance. Under accrual accounting, the monthly rent payment would be expensed in January, because it relates to revenue earned in January. However, the insurance bill provides coverage for the next six months, so only one-sixth of that bill ($800) would be expensed in January. The remainder ($4,000) would be recorded on the balance sheet as prepaid insurance and gradually expensed over the next five months, effectively recognizing the expense over the related time period.
Is accrual accounting the best method for your business? It might be. Indeed, it is the accounting method used by most mid-sized and large businesses in the United States. It satisfies Generally Accepted Accounting Principles (GAAP)—which are a common set of accounting rules, standards, and procedures. Here are four notable benefits of the accrual accounting method:
Real-time view of full financial picture:
Accrual accounting allows businesses to see their financial position at any given moment accurately. The balance sheet reflects all financial activity—including transactions that have occurred but not yet been paid for—to provide a more comprehensive and real-time view of a company’s assets (current and future economic benefits) and liabilities (future obligations). When done properly, accrual accounting is the method that provides the most complete view of what’s owned and what’s owed.
More accurate measure of company’s profitability:
Accrual accounting provides a more accurate representation of a company’s ability to earn income, a key indicator of financial health. By documenting revenue and expenses when they are earned and incurred, the income statement offers a precise measure of a company’s profitability over a specific period. Accrual accounting can be especially useful when revenue and/or expenses fluctuate monthly.
Helpful for strategic planning:
Accrual accounting matches revenue earned to related expenses incurred in the same period. The matching principle helps reduce major fluctuations in profits from one period to the next. By providing a real-time and accurate view of a company’s financials, accrual accounting allows business leaders to make informed decisions, helping with budgeting, forecasting, benchmarking, and long-term planning. Indeed, the information available through accrual accounting can be especially useful and helpful for strategic planning.
Compliance:
The IRS requires businesses with annual receipts above an inflation-adjusted threshold to use accrual accounting. In addition, lenders and investors typically prefer financial statements that comply with GAAP. This helps them compare your business’s financial performance over time and to other businesses and investments.
Accrual accounting is not without disadvantages. For some small businesses or sole proprietors, it may not be the best option. Here are the two main disadvantages of accrual accounting:
More complex than the alternative (cash accounting):
Accrual accounting can be more complex than cash accounting. Accrual accounting has a learning curve because it requires the tracking of deferrals and accruals. That results in the reporting of technical-sounding accounts—such as accounts receivable, accounts payable, deferred revenue, prepaid assets, inventory and accrued expenses—on the balance sheet. This complexity means businesses may need more experienced accountants or sophisticated accounting systems, which could increase operational costs.
Misleading financial picture for cash flow-focused small businesses:
Due to the nature of accrual accounting, there is a potential for misunderstanding or misinterpretation of a company’s available resources. Indeed, owners of growing small businesses that report healthy profits may not understand why they don’t have enough cash on hand to pay their bills. Profits should not be mistaken for cash flow. A business may appear profitable due to high amounts of accrued revenue, while actual cash on hand may be insufficient to meet immediate obligations, potentially leading to liquidity problems. However, a Statement of Cash Flow accompanying the financial statements would solve this issue.
Not all businesses use accrual accounting. Cash accounting—which is the primary alternative to accrual accounting—is a simpler method. With it, financial transactions are recorded when cash is actually exchanged. Put another way, revenue is recognized when cash is received, and expenses are recorded when they are paid. For small businesses or sole proprietorships, cash accounting can offer several advantages, including simplicity and a clear view of how much cash the business actually has on hand at any given moment. However, this method does not offer as comprehensive or accurate a picture of a company’s overall financial health as accrual accounting does, because it does not report money owed to the business, bills not yet paid, and other probable economic benefits and obligations.
At Padgett, our team of financial professionals is committed to helping small businesses build a better foundation for their financial health. If you have any questions about accrual accounting, we are here to help. Give us a call now or connect with us online to set up a confidential no obligation appointment. Our team provides small business accounting services nationwide.
