What Is Accrual-Basis Accounting?
It may be difficult to determine the bookkeeping method that's best for your small business, as there are multiple methods of accounting to choose from. These options include two popular approaches: cash-basis accounting and accrual-basis accounting. Unlike cash-basis accounting, the accrual method of accounting reports revenues and expenses at the same moment they're earned or incurred.
Whether you've received payment or paid a bill yet doesn't matter; your routine financial statements under an accrual-basis accounting system will show a clear picture of profitability for that period of time. For this reason, business owners should be familiar with the accrual method so they can make the most informed decision regarding when it might best serve their company's financial accounting strategy.
This article will explain what accrual-basis accounting is and detail several benefits of using this bookkeeping approach for recording transactions.
What Does Accrual-Basis Accounting Mean?
Accrual-basis accounting simply refers to recording accounts receivable and accounts payable so your company's balance sheet reflects every deposit and debit in real time. This means that income is recorded when it's earned and not when the actual cash is received. By the same token, accounts payable appear when they're initially incurred and not on the date you paid them.
This bookkeeping approach allows business owners to have a more accurate idea of their net income, which is helpful at the close of the tax year and during month-to-month business expense planning.
What Is the Difference Between Accrual-Basis Accounting and Cash-Basis Accounting?
Under Generally Accepted Accounting Principles (GAAP), accrual-basis accounting is favored over the cash-basis method because financial statements generated under an accrual system tend to reflect a company's profitability much more accurately because revenues and expenses are recognized within the same accounting period.
Under a cash-basis system, revenue recognition only occurs once the company receives the cash or its equivalent for any given accounts receivable. Likewise, expenses under the cash-basis method of accounting don't appear until the company pays debit with cash or its equivalent.
With accrual-basis accounting, a matching principle is at play. Cash transactions are recorded immediately, regardless of where the money is in the chain of transfer. This also means that an accrued expense is recorded on the balance sheet as a liability on or before the date that the actual goods or services were received.
That accrued expense will be recorded in two places: as an expense in the income statement and also as an accounts payable in the "current liabilities" portion of the balance sheet. The expense is then "matched" with the corresponding revenue. If any expense incurred during the accrual-basis accounting period goes unpaid, that liability is reported through adjusting entries on the last day of the bookkeeping period so a company's financial statements accurately reflect revenues earned and expenses incurred.
Who Uses the Accrual Method?
Most companies regard accrual-basis accounting as standard practice because of the fiscal clarity this system provides — a major benefit at tax time and always. The Internal Revenue Service (IRS) allows any small business with less than $25 million in annual revenue to choose its accounting method. Once they choose, however, that company can not deviate from the system they choose. It's likewise mandatory that every company's chosen method of accounting reflects its business operations.
An accrual basis of accounting is best (and usually required) for companies that conduct sales on credit or hold inventory. We'll review the advantages and disadvantages of accrual-basis accounting in more depth below.
Benefits of Accrual-Basis Accounting
Accrual-basis accounting has many advantages, including providing a much more viable picture of a company's income-to-debt ratio. The following list represents a few of the major benefits to working your business financials under an accrual system:
- Profitability visibility: Because accrual-basis accounting places revenue and expenses on the balance sheet in direct correlation to the time frame they apply to, the true relationship between a company's profit and expenses is more accurately revealed. For example, if your small business engaged in any prepaid expenses, such as paying for an entire year's worth of insurance upfront, that expense will register across all 12 months of the fiscal year rather than as just one lump debit at the beginning.
- Tax benefits: Business owners generally want to have an idea of how much income tax they're going to owe the IRS at the end of the year (and, perhaps, even be able to accrue some savings on that inevitable bill ahead of time). With accrual-basis accounting, small business owners can identify depreciation of assets in time to log them as a deduction for that tax year. This helps lower tax payments and conserve funds.
- Enhanced financial forecasting: Keeping a level eye on future staffing and inventory needs is essential for all successful businesses. The accrual method of accounting allows small business owners to gauge predictable revenue and expenses, thereby allowing for the creation of a more realistic budget.
- Danger of bad debts: As revenue recognition is not based on the actual presence or absence of cash in an accrual-basis accounting system, your cash flow statement may not be entirely aligned with what your balance sheet says is in the company coffers. Invoices and deposits are based on a great deal of estimation and guesswork with an accrual-basis approach, which can cause issues if the financial events in question end up not playing out the way the system planned.
- Short-term financial uncertainty: Accrual methods are based on a given accounting period, and businesses make all of their estimations and best guesses based on that allotted time frame. This means that if you need hard data regarding what cash your company has at hand this week, you may struggle to ascertain that figure with an accrual-basis system.
- Intense bookkeeping: GAAP rules and regulations exist regarding everything from what has to be disclosed in a company's financial statements to how certain fiscal events have to be measured in the accrual-basis accounting method. Bookkeeping is much more difficult with this system and comes with higher stakes, as mistakes can lead to loss of profitability and overspending.
Challenges of Accrual-Basis Accounting
Although preferred by many successful companies, the accrual method of accounting is neither foolproof nor necessarily easy. Many certified public accountants (CPAs) would agree that a cash-basis system is simpler to calculate. Here are a few of the other common challenges you may face with an accrual system:
Example of How to Record an Entry Using Accrual-Basis Accounting
Let's say that a graphics firm completes a $7,000 order for a client on May 5. That client then receives the final bill for that project a few days later and makes the full payment on May 20.
Under an accrual-basis accounting system, the revenue for this order would be recorded on May 5, even though the cash flow from this project will not be received by the company for another 15 days. Skynova's accounting software helps you easily record that sale in accounts receivable and the payment into the current assets portion of your balance sheet.
Keep Accurate Accounting Records Using Skynova
Every business owner needs to pay special attention to finances to be successful. There's no need for headaches or confusion when you entrust that all-important component of your company's well-being to Skynova.
Skynova helps small business owners with their accounting and financial statements by providing a general ledger wherein business owners can track expenses, store receipts, and journal any kind of financial transaction. Skynova also has customizable business templates to make the everyday affairs of your company run more smoothly. Check out Skynova today and feel secure in implementing a successful accrual-basis accounting system for your business.
Notice to the Reader
The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a CPA before deciding on any formal accounting system for your business.