In 1916, a new form of accounting revolutionized the way we work.
With the introduction of accrual basis accounting, cash was no longer necessary for a business to declare its revenues. A precursor to credit cards, it established a system of good faith in which money promised to or by a business could be accounted for and redirected as needed. This approach has since become standard across the country, especially among mid-market and enterprise businesses.
Cash is still king for millions of people, and there’s nothing wrong with running your small business on traditional cash-based accounting. With a little help from accounting software, managing your books and following your paper trail with the cash method is quick and painless.
But understanding accrual accounting is a smart play, no matter how you slice it, especially if you plan on growing. No pressure, though: We love your company just the way it is.
What is accrual basis accounting?
Unfortunately, when your customer signs on the bottom line, that doesn’t always mean a fresh wad of bucks in your pocket. Transactions can take weeks or even months to fully complete.
With the accrual basis of accounting, you don’t have to wait to measure your company’s success, health or assets. These revenues are recognized as earned on the initial date of transaction, so you can move forward with your money matters, rather than twiddling your thumbs waiting for installments.
Accrual basis definition
A business accounting approach where finances, both incoming and outgoing, are accounted for in the bottom line and usable on the day of the transaction, even if the cash assets are not exchanged in full at the time.
In a way, the accrual accounting method is an honor system. When you are executing hundreds, or even thousands of transactions a day — many with belated payment due dates or installments — cash itself is fluid and sometimes elusive. This makes it difficult to operate to your full potential. The accrual basis allows you to make decisions based on the capital you are promised, in addition to the bona fide assets in your accounts.
If you perform a service today, for example, your customer’s bill may have a due date of a week from now. In the time between now and then, you will want to purchase goods, pay your salaries, plan your budgets and report to your investors.
Rather than wait for your many transactions to be resolved, you can find out where you stand and manage your resources without delay. If you’ve ever had a friend say, when it comes to money, “Don’t worry; I’m good for it!” — this is just a more official version of that.
How accrual accounting works
In an accrual accounting scenario, your varied revenues are logged as “earned” when the sale occurs, regardless of the payment schedule. Transactions without cash in hand are booked into your current assets under the “accounts receivable” section in your balance sheets.
Typically, if these transactions will be paid off in a year or less, they can be considered short-term assets. Anything that is still owed to you is also referred to as a “liability.” If that word sounds familiar, you’re not imagining things. It implies a degree of risk.
Just as an embarrassing sibling is a liability in public, your current liabilities, such as money owed, can create problems if they are not resolved as planned. (A problem like, say, bankruptcy.)
You and your customers enter an agreement that bills will be paid on time. With the appropriate screening and established trust with a contract, this shouldn’t be an issue. But the possibility that money isn’t received, however small, is an assumed risk with this type of accounting.
Regarding your cash outflow, you can track money owed for goods, services and other creditors in the “accounts payable” section of your books. People owe you, and you owe people, and that’s completely normal. You may decide on a big purchase and subtract the eventual final cost from your short-term assets in accounts receivable. These purchases add to your overall liabilities, but this allows you to keep your liquid assets safe in the bank, and those sections of your balance book unbothered.
In this way, the accrual system is like a revolving door of short-term assets kept separate from your long-term assets. When considering your bottom line, though, you can factor in both amounts.
Cash vs. accrual
When considering cash basis vs. accrual basis for your company, a key consideration is the aforementioned risk. According to the Internal Revenue Service, once you elect an accounting method, you must apply it to all aspects of your business.
Reporting your taxes is an another factor to consider. The following is an excerpt from the IRS website:
Under the cash method, you generally report income in the tax year you receive it, and deduct expenses in the tax year in which you pay the expenses.Under the accrual method, you generally report income in the tax year you earn it, regardless of when payment is received. You deduct expenses in the tax year you incur them, regardless of when payment is made.
In other words, you are expected to pay taxes on all your implied earnings, even if they aren’t paid off. This can be precarious if you are dealing with a majority of accounts receivable liabilities based on your transaction history.
Risks of accrual basis accounting
Even before taxes, the accrual method can lead to financial woes if not handled delicately. If you run out of cash at any point, you may face legal issues with your creditors and risk bankruptcy, even if your balance sheet reports profitability. Again, the chances of this are slim if you are attentive and make necessary adjustments to your outflows, but it’s an unfortunate reality for many businesses. A few minor mistakes can be fatal.
There is a degree of estimating with accrual basis accounting. The likelihood for obsolete inventory and product returns, for example, needs to be factored into the equation. For this reason and others, accrual-basis has a steeper learning curve than cash-basis. You can work with an accounting firm or financial consulting provider to educate your accountants and ensure a smooth ride if and when you go this route.
If not given care and hawk-eyed precision, the accrual method can lead to pothole-sized oversights. If one or two payments don’t come in on time, it can reverberate through your entire operation.
Benefits of accrual basis accounting
It’s not all doom and gloom. There are significant upsides to accrual accounting when things run smoothly.
Revenues and expenses are matched on the spot. For example, if you spend $1,000 on materials but are guaranteed $5,000 for the work, you can book a net profit of $4,000, even if it’s a few months before that money rolls in. This is helpful for management as it makes decisions and lays groundwork for the future. In cash basis accounting, a job that has greater in-the-moment expenses than profits can be viewed as a loss and impede certain decision-making abilities.
If your office needs equipment or a talented IT hire, it can be hard to justify these choices without the dough in hand. The biggest advantage of accrual basis accounting is it empowers wise decisions that instantly increase your operational efficiency and profit potential.
Modified cash basis
The modified cash basis of accounting is a hybrid of the two primary accounting bases. In this scenario, your financial team records income when it’s signed off on (i.e., accrual basis), but only records deductions once they are paid in full (i.e., cash basis). Though this may limit your spending power, it may be a safe compromise that minimizes some of the risk associated with accrual-based expenses.
These are big decisions for your business and they deserve a fair amount of dedicated research and discussion among your decision-makers. We recommend sitting down with one or more financial consulting providers to help form the most educated accounting plan. No two businesses are the same and you should shape the financial approach that is best for you.
When is accrual basis required?
If your business operates in the U.S. and falls into a particular category, the IRS requires the accrual basis of accounting for tax-reporting purposes. These involve the following conditions:
- Carrying inventory/selling goods
- C corporations
- An average annual gross revenue of more than $5 million
These restrictions certainly limit the candidates for cash accounting. If you’re a small upstart that only offers a service, cash basis is a sensible way to handle your finances and keep tabs on your assets. If you operate a farming business, you are also entitled by the IRS to use the cash method. In most other cases, though, it appears that the accrual basis is not only beneficial, it’s required by law.
Understanding your accounting process
Sound financial practices are a cornerstone of success, and there is certainly a lot to digest on the topic. Implementing quality accounting software and being diligent with your records is a must for any business in its early stages. You can track down free accounting software great for getting started. There is also small-business accounting software catering to solopreneurs and smaller teams.
If you’re interested to learn more about the accounting process as a whole, you can read about the basics of the accounting cycle, broken into 8 easy steps.