Did you know the accounting method you choose to utilize for your business can have a significant impact on your company’s finances? Not only does your accounting method impact the usefulness of your financial statements, it also plays a large role in how you monitor your tax burden and cash flow.
While most small businesses (those under $26 million in annual revenue, according to the IRS) have the option to choose their accounting method — either accrual accounting or cash accounting — there are more than a few reasons accrual accounting may be the best method for the typical small business.
What is accrual accounting?
Before you can determine if accrual accounting is the best method for your business, let’s start with a quick overview of how this type of accounting works.
Accrual accounting means you record your business transactions at the moment they occur, instead of when you receive a payment or make a payment. Even if you use credit to make a purchase and aren’t required to pay it back for days or weeks, accrual accounting records the expense at the moment you make the purchase.
Similarly, your sales are recorded the moment they occur — even if your customers aren’t required to make a payment for 30, 60 or 90 days.
Accrual accounting also applies to prepayments and noncash assets like real estate, investments and utilities. Each of these totals is recorded as you earn the revenue or accumulate the expenses, even if payment isn’t yet due.
There are three key differences between accrual accounting and cash accounting
While accrual accounting counts transactions at the moment they occur, cash accounting doesn’t record your revenue and expenses until the money changes hands. If a customer makes a purchase on credit today, with cash accounting, that purchase won’t be recorded until the day they pay off their invoice — up to 90 days or more from today, depending on your payment terms.
This same concept applies to employee wages. Accrual accounting accounts for wages as they are earned by your employees, but cash accounting marks these costs as expenses only on the day the check is issued or the deposit is made.
A third significant difference between accrual accounting and cash accounting is the financial snapshot they offer. Because cash accounting only notes completed transactions— not pending ones — it offers a less accurate view of your business’ current financial standing.
If many of your customers buy on credit, or if your company often utilizes credit for expenses, cash accounting fails to paint a clear picture of your upcoming revenue and expenses.
What are the benefits of accrual accounting?
The best benefit of accrual accounting is the accuracy it offers your decision-makers. Particularly for companies that allow customers to pay over an extended period of time, accrual accounting allows you to understand what cash is scheduled to enter or leave your business in the short term.
A second benefit of accrual accounting is that it matches your payments and earnings to the season they occurred in. This gives you a better understanding of the seasonal fluctuations in your business.
Cash accounting only records revenue once the money is received, which makes it difficult to quickly see which weeks, months and quarters are the most profitable for your business. Accrual accounting gives you granular information about the exact days that are the most profitable, and most expensive, for your business.
But accrual accounting does have drawbacks
Accrual accounting gives you a valuable view of your business’ financial health, which is vital for forecasting and planning. But using the accrual accounting method alone doesn’t provide much visibility into your company’s current cash-on-hand.
That’s why many companies supplement accrual accounting with a few insightful financial reports that help fill in the gaps. A second drawback to accrual accounting is that it can be more challenging to set up and manage than cash accounting.
Accrual accounting comes with a specific set of reporting rules and a detailed process that guides how your business records revenue and expenses. Accrual accounting can also complicate your filings at tax time.
The easiest way to handle accrual accounting? Outsource it
If your business already uses cash accounting and you wish to switch to accrual accounting, or if your team is overwhelmed by monthly accounting tasks, consider hiring an outside finance and accounting firm to help manage your books. An external accounting team can work with you to update your general ledger, file the correct financial reports and tax documents, analyze your cash flow and give you a more clear view of your company’s financial health.
Accrual accounting is a bit more complicated than cash accounting. But the insights, health indicators and transparency it offers business leaders are invaluable.
Want more? Escalon has helped over 5,000 companies to optimize routine business functions with our outsourced accounting, finance, HR and insurance services. Talk to an expert today.