What is accrual accounting?
- An accounting method where income and expenses are recorded before money is received or paid out.
- Differs from cash basis accounting, where income and expenses are recorded when money is already received or paid out.
- Has the benefit of accurately matching income and expenses, thus giving a better picture of your business finances.
Accrual accounting is an accounting method where income and expenses are recorded based on events, such as when a sale of goods or services occurs, without money being paid out. To understand accrual accounting, let’s take a quick look at what “accrual” means.
Accrual is an entry adjustment made in an accounting book that records the income earned or expenses paid without any exchange of money. The revenue and costs are not yet registered in the accounts. This accounting method is often used by companies where there are a lot of credit transactions, where the goods or services are sold on credit and that there was no exchange of money.
For example, you perform accrual accounting when you list down your income or profits earned before you receive cash. If you sell electronics, you record your earnings on your accounting books when the transaction is complete even if you have yet to receive payment for the items you have sold.
In the same way, you record your expenses for shipment, delivery, and other costs even when you have not withdrawn money from your business bank account yet. This method is usually how financial reports of companies are handled.
Accrual accounting vs. cash accounting
Depending on how you want your accounting done, there are two methods that you can choose. They are either accrual or cash basis. Cash basis accounting is the exact opposite of accrual accounting. Cash basis accounting is where income and expenses are recorded when money is received or paid out.
An essential difference between these two accounting methods is knowing how well your money is tracked and represented.
Accrual accounting does an excellent job of matching income and expenses. It isn’t used for tracking cash flows since it recognizes the income before it’s received and expenses before they’re paid out. But it will give you an exact representation of your company’s profit standing. On the other hand, cash basis accounting is an excellent way of tracking cash flows because it records the transfer of money only when they occur. However, it doesn’t accurately match income and expenses during an entire accounting period.
For tax planning purposes, you can use either accrual accounting or cash basis accounting. According to the Internal Revenue Service (IRS), more significant companies that earn $5 million gross sales and up must use the accrual accounting method.
Pros and cons of accrual accounting
- Matches your income and expenses more accurately, thus giving you an accurate snapshot of the financial health of your company.
- Shows the coming and going of your income, debts, and expenses more accurately.
- Serves as an excellent reminder for expenses purchased on your credit transactions.
- Provides unreliable tracking and reporting cash flows compared with cash basis accounting.
- Makes it easy to overlook that your income is not yet in your bank account.
- Can leave you unaware of the availability of your funds, which could lead to cash flow problems.
If there are no requirements, you can consider the pros and cons of this method that are related to your business before deciding if it’s right for you. To determine if you need accrual accounting for your books, be sure to consult an accountant or a financial expert.