Accrual accounting explained: What it is and if your business needs it

Accrual basis accounting records financial transactions as they occur, regardless of when cash changes hands. This method provides a more accurate picture of a company's financial health and is a requirement for many businesses.

This article will explain the fundamentals of accrual basis accounting, how it operates, and its advantages over cash basis accounting. Understanding these concepts will help you determine the most suitable accounting method for your business.

By the end of this article, you will have a clear understanding of accrual accounting and whether it’s the right fit for your business needs.

Understanding accrual basis accounting

Accrual basis accounting is a widely adopted accounting method where financial transactions are recorded when they are incurred, not when payment is made or received. This means that revenue is recognized when it's earned, and expenses are recognized when they occur.

Imagine you run a retail store with a significant amount of inventory. With accrual accounting, you can track your inventory levels, purchases from suppliers, and sales in real-time. This provides a clear view of the value of your goods, even those still on the shelves. In contrast, other methods might only show your immediate cash flow.

If you purchase inventory on credit, the expense is recorded when you receive the goods, not when you pay for them. This expense is matched against the revenue it helps to generate, giving you a more accurate assessment of your profitability.

Similarly, when you make a sale and the customer pays with a credit card, the revenue is recorded at the time of the sale, not when the payment settles in your bank account. This allows you to track your sales performance accurately and make more informed business decisions.

The mechanics of accrual accounting

So, how does accrual accounting work in practice? It all starts with journal entries. In accrual accounting, you record transactions when the service is delivered or the product is sold, rather than waiting for the payment to be processed. This applies to both your income and your expenses.

Accrual accounting operates on the matching principle, which dictates that revenues and their associated expenses should be recorded in the same accounting period. This approach provides a more comprehensive view of a company's financial performance over the short and long term by linking costs directly to the revenues they help generate.

This method gives a more realistic picture of a company's financial health, which is why it is the standard for most businesses. It helps in understanding the profitability of specific periods and in making strategic financial plans.

For instance, if a construction company completes a project in December but doesn't receive payment until January, the revenue is recorded in December when it was earned. Similarly, any costs associated with that project are also recorded in December, ensuring that the financial statements for that period are accurate.

What an accrual is

In accounting terms, an accrual is the recognition of revenue or expenses that have been earned or incurred but not yet paid or received. It’s about recording financial events as they happen, providing a more up-to-date view of your business's finances.

For example, if you are a freelance writer and you complete an article for a client, you can record the income as soon as the work is done. You don’t have to wait for the client to pay the invoice to recognize the revenue. This immediate recording of income helps you to better gauge your business’s financial performance.

This approach is crucial for businesses that operate on credit or have long payment cycles. It allows them to have a clearer understanding of their financial position at any given time, which is essential for effective financial management.

By recording income and expenses as they occur, you can make more informed decisions about your business, from managing your cash flow to planning for future growth.

Accrual accounting vs. cash basis accounting

While accrual accounting is widely used, it’s not the only method available. The alternative is cash basis accounting, which recognizes revenue and expenses only when cash is exchanged.

Here are some key differences between the two methods:

• Popularity and requirements: Most businesses use the accrual method. In fact, it's a requirement for companies with an average annual revenue of $25 million or more over a three-year period.
• Problem-solving and transparency: Accrual accounting offers a more detailed view of a company's financial health. It allows you to track payables and receivables, which is crucial for managing your cash flow effectively. On the other hand, cash basis accounting is simpler and focuses on the cash you have on hand, which may not be sufficient for long-term planning.
• Target users: Cash basis accounting is typically used by sole proprietors, small businesses, and those who primarily deal with cash transactions and don't manage inventory. It provides a snapshot of the business's finances at a specific moment in time.

For a deeper dive into cash basis accounting, you can explore more resources to understand its nuances.

Choosing the right method for your business

Deciding between accrual and cash basis accounting depends on your business's specific circumstances. There isn’t a one-size-fits-all answer, but there are some clear indicators that can help you make the right choice.

If your business manages inventory, you are required to use the accrual accounting method, regardless of your revenue. This is because accrual accounting provides a more accurate way to track the value of your inventory and the cost of goods sold.

Furthermore, if your business extends credit to customers, accrual accounting is essential. It allows you to record revenue at the point of sale, rather than waiting for the cash to arrive in your bank account. This gives you a more accurate picture of your sales performance and financial position.

For businesses seeking external financing, accrual accounting is the preferred method by banks and investors. It provides a more comprehensive and accurate view of a company's financial stability and its ability to manage debt, which is a critical factor for lenders.

Manually tracking invoices and payments in accrual accounting can be complex and time-consuming. To streamline this process, you can use a platform like Zenceipt, which automates the collection of invoices and receipts from your email inbox, simplifying your bookkeeping and ensuring your financial records are always up-to-date.

Ultimately, while accrual accounting is more complex than cash basis accounting, it offers a more robust and accurate way to manage your business's finances. It provides the insights you need to assess your company's performance, make informed decisions, and plan for a healthy financial future.