What is Accrual Accounting?

WHAT IS ACCRUAL ACCOUNTING?

Accrual accounting is a relatively straightforward process in accounting. It involves matching the revenues and expenses to the time it has taken to earn the revenue or spend it as expenditures. It is a logically structured method of counting your invoices as income.

The phenomenon behind accrual accounting is: The transactions are documented even before the payments have been received. This process perfectly assesses and evaluates the robustness of the business’s financial structure.

How does Accrual Accounting work?

Accrual Accounting basically works on the basis of financial events, that are identified via the matching principle (matching revenues with expenses. As a result, the business becomes able to match the current cash inflows/outflows with the expected future values to show an accurate financial position of the company.

Accrual accounting originated with the rising complexity of business transactions and increase demand of crystal clear financial picture. Despite the complexity of the method and expensive implementation, it is the most suitable accounting style for growing businesses.

When a sale is made on credit, this shows a revenue generation over a long duration. Eventually it is going to reflect in the financial statements. Accrual accounting makes it possible to have an instant feedback on the expected incoming and outgoing cash. The immediate response enables the company to manage the current resources better and provides help in future planning.

Accrual Accounting for Small Businesses:

Being a small business owner, it is very exciting to watch your business grow. You are most likely to grab any opportunity that will help your business to nourish and polish your brand. For this reason, most small business owners put all their efforts to look for such elements. Hence, they often overlook the importance of accounting-related decisions.

The critical question is whether you are going to use cash-based accounting or accrual accounting. Typically, accrual accounting is the perfect choice for a growing small business. But to clear up any confusion, we have done a comparative analysis of both the systems for you to better understand the selection.

Comparison of Cash-Based Accounting and Accrual Accounting:

If you are an entrepreneur, then most probably you have to learn basic accounting by yourself. In the US, you can opt for either of the accounting methods, but you must have the knowledge of both of them. In Canada, the majority of businesses must use the accrual accounting method.

• In cash-based accounting, the rules are quite simple. A sale is not documented until you receive the payment from the customer. Similarly, any expense is also not recorded until you have paid for it. In simpler words, should there be money transactions, only then you can mention them in accounting books.
• The drawback of cash-based accounting is that it might exaggerate the business’s overall financial situation. As it shows off the large cash received in the books but does not expose the big future payable amounts. This can mislead a vendor and make the wrong assumption. They might think that the company is making a lot of money. In reality, the business is going to lose more than the earned profit.
• In accrual accounting, sales are documented instantly in the accounts receivables. You do not have to wait for the actual payment rather sending an invoice to the customer is sufficient to update the accounts. Similarly, as soon as you receive an invoice from the vendor the accounts payable are recorded.
• The disadvantage of accrual accounting is that it does not show a clear cash flow. This can lead to a shortage of cash. The second drawback of accrual accounting is that it is not easy to apply in the business. It is a complicated method to implement.

Both of the above-mentioned methods have their pluses and minuses. Since you will have to make an investment in selecting the accounting method, therefore you should learn and research about both of the methods. Finally, make an informed decision.

An Example:

Suppose you have started a brand-new tiling company. In the month of April, you managed to complete 10 projects. The total worth of 10 projects was $5000. By the end of the month, you received payments of 5 projects totalling $2500. In addition to this, you bought some tiles and paid an invoice for $800 for it.

If you are using a cash-based accounting method then your profit will be calculated as $2500 minus $800 which is equal to $1700. On the other hand, if you use accrual accounting then your calculated profit will be $4200 because that is $5000 minus $800.

See how the accrual accounting method can make a huge difference in your financial statements. Even in an exactly similar situation, just by choosing accrual accounting over cash-based accounting, your financial books can have promising figures.

Why do small business owners still choose cash-based accounting?

There are a few reasons why small businesses still prefer cash-based accounting over accrual accounting. Let us get to know them.

Too much work to do and decisions to make:

For the new business owners, cash-based accounting seems an easy and time-saving method. What interests the new entrepreneur is a simple financial statement creation. It only involves checking bank accounts.

Mostly small business customers pay immediately:

Small businesses often have a pricing model that allows immediate payments. Therefore, there is no requirement for account receivables. Such types of businesses might not want to indulge in a relatively complex accrual accounting method.

Cash-based accounting affects payable taxes:

Suppose a small business provides a service near the year-end, say December but the payments do not arrive until the next year. In this case, you would not be liable to pay tax on this income if you choose cash-based accounting. But next year you will be paying the tax. So it is not really that big of a benefit. Despite the all above-mentioned advantages, cash-based accounting may not be the best accounting method for a small business.

Small business should opt for Accrual Accounting

Despite the fact that accrual accounting is a bit complex to use, there are some awesome reasons why small businesses should choose to use it, even if you aren’t required.

Tracks revenue and expenses easily:

When you start off a new business, you have no idea how complex it is going to get. Suppose your business has a sudden boost in demand and you now have to deal with more customers than expected. In this instance, accrual accounting provides you with peace of mind by recording the amount receivables and payable. It gives you a clear picture of where is money is going and from where it is coming.

Creates comprehensive financial statements:

With a growing business, the responsibilities also increase. You should know that someone will review your financial books so it is necessary to maintain them accurately. With the help of accrual accounting, you will be able to portray a better picture of your business’s financial structure.

Calculates best key ratios:

It is essential to keep your bank happy. Because when the business starts to grow, you require more credit for expansion. For this reason, the banks conduct an evaluation in which the bankers calculate certain ratios. Accrual accounting is best to produce the ideal ratios.

The accrual accounting method is generally used by publicly-traded companies. It is a famous choice among business owners because it accounts for all revenue and expenses quite smoothly. It shows out earning overtime unlike intermittent records in cash-based accounting method.

Hire An Expert:

When you have made your mind, switching is not that big of a problem. We recommend you to hire a professional. Talk to your CPA about any possible tax situations prior to taking any step further. The key is to stay consistent after making a switch to accrual accounting. It is going to benefit you in the long run by providing great credit.

For a small business owner, it is pretty much a solo performance where one person has to keep everything in check be it marketing, sales, accounts, or say every aspect of the business. It is very important to keep your financials in order so that your business flourishes smoothly. To stay on top of your business financials as well as keeping your mind free, consider hiring an expert.

Centrosome Inc. is a bookkeeping firm that offers expert financial advice. We are based in Ottawa, Canada, and help small businesses with bookkeeping in Canada and the United States.

To learn more about the services we offer at Centrosome Inc. please click here, or read what our clients are saying about us, here. If you have any questions about how we can help you, contact us.