What is accrual accounting?

For example, let’s say you have a software contract with a customer who pays after receiving the final product. You incur expenses while working on the project, like supplies and wages. Regulatory agencies require businesses using the accrual method to recognize the expenses in the same period as revenue, which might require your company to record an accrual journal entry.

Most notably, accrual accounting reports accounts receivable and accounts payable on the balance sheet. Accounts receivable represent money earned but not received from customers, while accounts payable hold money owed but not paid to vendors and other third parties.

Moreover, compliance with the accrual accounting method does require more work from members of management and your accounting team. For one, you may need to make accrual journal entries to report transactions not recorded on the balance sheet, like payables and receivables.

The Use of Accrual Accounting

For some companies, the use of accrual accounting is required. Companies with an average revenue of $25 million or greater over the past three years are required to file tax returns using the accrual accounting method.

Additionally, companies that issue financial statements in accordance with Generally Accepted Accounting Principles (GAAP) will usually report using the accrual basis of accounting. This is because GAAP doesn’t recognize cash accounting as an acceptable accounting practice. Compilations, reviews, and audits conducted by accountants will generally require your business to remit accrual basis financial statements.

Growing businesses also resort to the accrual basis of accounting when issuing financial statements to lenders, investors, and other third parties. This is because the standardized format of accrual accounting leads to more comparability and transparency into the financial health of your organization.

Accrual vs Cash Basis Accounting

Cash basis accounting is another accounting method that business owners utilize. Cash accounting only recognizes transactions when they hit the checking account, regardless of whether the performance obligation is satisfied. Additionally, no year-end journal entries are required as what cleared the bank account is what’s reported.

This means that a pre-payment from a customer will be reported as revenue even if your business hasn’t completed your end of the deal. On the contrary, accrual accounting would have reported this transaction as a liability on the balance sheet, deferring the revenue until your business earns it.

Cash basis accounting does not use payable and receivable accounts. Instead, all cash transactions are immediately reported on the income statement. This makes overall reporting and maintenance simpler, but it can lead to poor insights into the true financial health of your organization.

Most accounting systems have the ability to populate both cash and accrual accounting reports. This means that your business can leverage both accounting methods for internal reporting. For example, you might use cash basis reports to understand the transactions that took place during the period and accrual reports to send to investors and other external third parties.

It’s also important to note that Schedule C filers, which include sole proprietorships and single-member LLCs, will report using the cash basis of accounting. Schedule C on the 1040 does not allow reporting using the accrual method of accounting.

The Benefits of Accrual Accounting

Accrual accounting has a variety of benefits even if your organization isn’t required to use this method. Let’s explore some of these benefits in more detail.

Greater Accuracy

The first advantage of accrual accounting is the accuracy it provides, especially when it comes to the matching principle. For example, let’s say that you are issuing end-of-the-year financial statements. Bonuses for the year are accrued and total $50,000.

With the cash basis of accounting, this transaction wouldn’t be present in your financial statements. However, under the accrual method, these expenses will be accrued and reported on the income statement as an expense and the balance sheet as a payable.

The bonuses do relate to the prior year, as they are for work performed generating revenue. This makes the financials more accurate when they are included. Not to mention that members of management, investors, and lenders have expanded insights into upcoming payments with the amount recorded.

Transparency Into Financial Health

The accrual basis of accounting also leads to more transparency in the financial health of your organization. This makes it easier for members of management to make informed decisions surrounding growth and cash flow.

For example, let’s say that you’ve been keeping your balance sheet on the cash basis of accounting. Your cash account will only show payments that have actually been received or paid. What happens if you have $10,000 in outstanding checks?

Your cash balance on the balance sheet will show $10,000 more funds than you truly have on hand. This can result in overdrafts and uninformed decisions that hinder cash flow.

Moreover, the use of payables and receivables is also critical for cash flow management. These accounts help you track which customers owe you money and who you owe money to, helping you build beneficial relationships while still prioritizing cash flow.

Expanded Growth Opportunities

Financial accounting with the accrual method can open the door to expanded growth opportunities. Since accrual accounting leverages insights into cash flow and provides a true picture of the financial health of your organization, you can make informed decisions surrounding growth.

For example, let’s say your business needs to purchase a $10,000 piece of machinery. You currently have $12,000 in your bank account. Buying the piece of machinery right away could put you in a tough cash position, especially if you have outstanding checks.

You dig deeper into your financial transactions and find that a customer has a $5,000 invoice due in five days. Now, you can plan on purchasing the piece of machinery once the customer makes their payment, ensuring you have safe cash levels, while still giving you the opportunity to grow.

GAAP Compliant

Even if you aren’t required to report on the accrual method based on the gross revenue test, using this method for financial accounting is beneficial for GAAP compliance. Cash accounting is a recognized method for issuing financial statements. This means if lenders, investors, and other third parties request financial statements with assurance, you will most likely need to use accrual accounting.

The Financial Accounting Standards Board (FASB), which is the company that oversees GAAP, chooses accrual accounting as an accepted accounting method because of the transparency and insights it provides for the accounting period. For one, there’s greater comparability between other companies in the industry. In addition, set standards make it easier for companies to maintain compliance.

Summary

• Accrual accounting recognizes revenue and expenses based on when contractual obligations are satisfied.
• Accounts receivable and accounts payable accounts are used to house money owed from customers and expenses you owe to vendors.
• Cash accounting records transactions when they hit your checking account, with no payable or receivable accounts used.
• Companies with over $25 million in gross receipts over the past 3 years are required to use accrual accounting.
• Accrual accounting leads to greater accuracy, transparency into your organization’s financial health, expanded growth opportunities, and compliance with GAAP.