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Everything you need to know about accrual accounting

Every business needs accurate, well-maintained financial records.

Accrual accounting is a method whereby revenue and expenses are recorded when a transaction is realized—regardless of whether cash has actually been exchanged.

It may be the best accounting method for your company. At Padgett, we provide trustworthy and comprehensive accounting services for small businesses. We’re committed to empowering our clients. In this article, you’ll find an overview of the most important things you need to know about accrual accounting.

What is accrual accounting?

Accrual accounting is a method used by businesses to record revenue when it’s earned and expenses when they’re incurred—irrespective of when cash transactions take place. It’s based on the matching principle, which holds that both revenue and expenses should be carefully matched and recorded in the same accounting period that they occur in order to provide a more accurate reflection of a company’s financial situation.

Under accrual accounting, businesses report revenue earned but not yet paid as receivables on the balance sheet. Likewise, accrual-basis businesses report expenses incurred but not yet paid as liabilities on the balance sheet. The use of accrual accounting results in other technical-sounding accounts on the balance sheet, such as prepaid assets, work-in-progress inventory and contingent liabilities.

An example of accrual accounting

To understand how accrual accounting works, it’s useful to look at a real-world example. Consider a small pool contractor. In June, the business installed a pool for a customer and sent the customer an invoice for $40,000, payable within 30 days. The company also paid $25,000 in materials and labor expenses in June when it installed the pool. Using accrual accounting, the contractor would report the revenue for the job when the invoice was sent in June, even though the customer hasn’t yet paid it. The contractor’s balance sheet would show a receivable for the outstanding invoice.

Regarding expenses, the contractor would record the $25,000 in materials and labor expenses for the job when they were incurred in June. In addition, any unpaid expenses associated with the job—for example, unpaid compensation to workers or a bill that’s payable in July for materials received in June for the same job—would also be expensed in June. These yet-to-be-paid costs also would be reported as accrued expenses and payables on the balance sheet.

As this example shows, accrual accounting matches revenue earned with the expenses incurred in the accounting period. This method provides a clear picture of profitability.

Benefits of accrual accounting

Is accrual accounting the best method for your business? It might be. Indeed, it’s 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 five notable benefits of the accrual accounting method:  

  1. Real-time view of the full financial picture: Accrual accounting allows businesses to accurately see their financial position at any given moment. The balance sheet reflects all financial activity—including transactions that have occurred but not yet been paid—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.  
  2. More accurate measure of company’s profitability: Accrual accounting provides an accurate representation of a company’s ability to earn income, a key indicator of financial health. By documenting revenue and expenses when they’re 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 over time.
     
  3. 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. Accrual accounting makes it easier for 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 in strategic planning.
     
  4. Compliance: The IRS requires businesses with average annual gross receipts for the three prior tax years above an inflation-adjusted threshold to use accrual accounting. (Before the Tax Cuts and Jobs Act increased the threshold for the accrual accounting requirement to an inflation-adjusted $25 million starting in 2018, the threshold was generally only $5 million.) There may be some advantages to using the accrual method for tax purposes. For example, accrual-basis businesses may be allowed to defer income on certain advance payments and deduct year-end bonuses that are paid within the first 2½ months of the following tax year.
     
  5. Access to capital: Lenders and investors typically prefer financial statements that comply with GAAP. Accrual-basis statements help them compare your business’s financial performance over time and to other businesses and investments.
     

Drawbacks of

Accrual Accounting

Accrual accounting isn’t without disadvantages. For some small businesses or sole proprietors, it may not be the best option. Here are the three main disadvantages of accrual accounting:

  • Complexity: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-focused small businesses: Due to the nature of accrual accounting, there’s 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 shouldn’t be mistaken for cash flow. Owners of businesses that use accrual accounting should refer to the statement of cash flows for a clear understanding of the sources and uses of cash during the accounting period.
  • Misalignment with the ability to pay taxes: Businesses that use the accrual method may be required to report taxable income before they receive cash payments from customers. This can create hardships for businesses without cash on hand to pay their current tax obligations.

Understanding the primary alternative: cash accounting

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 exchanged. Put another way, revenue is recognized when cash is received, and expenses are recorded when they’re paid.

For small businesses or sole proprietorships, cash accounting can offer several advantages, including simplicity and flexibility to control the timing of income and deductions for tax purposes. However, this method doesn’t offer as comprehensive or accurate a picture of a company’s overall financial health as accrual accounting does because it doesn’t report money owed to the business, bills not yet paid, and other probable economic benefits and obligations.

The use of cash accounting also can make it difficult to compare a business’s performance over time or against competitors. This can be a major disadvantage when applying for business loans or attracting equity investors to pursue growth opportunities.

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