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.
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.
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.
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:
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:
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.