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How choosing the right accounting method can help your business grow

Posted by Neha De

September 28, 2021    |     3-minute read (556 words)

Accrual accounting is one of two standard accounting methods used by businesses; the other is cash accounting. Accrual accounting evaluates an organization’s position and performance by identifying economic events regardless of when transactions occur. Meanwhile, cash accounting only records transactions when payment is made or received.

The basic concept of accrual accounting is that economic events – meaning revenue and expenses – are recognized and recorded when the transaction occurs instead of when payment occurs. Accrual accounting allows the current cash inflows or outflows to be integrated with expected cash inflows or outflows to give a more comprehensive picture of a business’ current financial position.

Accrual accounting method helps…  
  1. Improve the financial picture – Using the accrual accounting method entrepreneurs can get a quick glance at their company’s financials, to see whether their business is profitable, what the source of the profit is and where most of the money is being spent. 
  2. Stay GAAP compliant – In the U.S., “generally accepted accounting principles” is considered the industry standard for putting together financial statements. In fact, businesses with $1 million in annual inventory sales or $5 million in annual sales are legally required to use the accrual accounting method as part of GAAP to report their finances and for income tax preparation. Meeting GAAP requirements allows an organization to be easily assessed by investors and other financial institutions. 
  3. Improve accuracy – Accrual-based accounting provides businesses a more realistic picture of their resources and financial responsibilities. This allows them to more accurately manage the ups and downs (such as the income and debts) of financial activity. 
  4. Plan for growth – Accrual accounting makes it easier to plan the future, because it is accounting in real time. Business owners do not have to wait to receive payment to know how much profit they have made. This allows them to come up with ways to generate more revenue or improve sales to keep progressing.
  5. Access credit – To survive or to expand, most companies depend on credit. The accrual accounting method allows them to record and measure credit – both owed as well as owing credit. 
But, accrual-based accounting can be... 
  1. Quite resource-intensive – Accrual accounting adds paperwork and complexity to a company’s financial reporting system, so entrepreneurs tend to view it as more expensive and laborious to implement. Because a firm records revenues before they actually receive the payment, cash flow needs to be tracked separately.
  2. Inaccurate in terms of the short term – Even though accrual-based accounting gives a better long-term view of a business’s finances, the cash-based method provides a better picture of funds in the bank account. This is because accrual accounting accounts for cash that is yet to come in.
Caution: Unless you have meticulous bookkeeping practices, an inaccurate short-term view of your small business’s finances could be devastating. The books could end up showing a false picture, implying that a large amount of revenue is accounted for even though the bank account is completely empty.

Takeaway

Accrual-based accounting offers an organization with the real-time financial status of its finances by taking into account expenses incurred and paid in addition to revenue earned and received. The IRS also usually requires companies with inventory to use accrual-based accounting. This is because inventory is considered an asset for a business — enterprises usually purchase inventory on credit and pay for it later. 

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