When most people start a small business, they suddenly find they need to learn accounting skills.
This isn’t necessarily difficult, and there are two primary accounting methods: cash and accrual accounting.
Each has pros, but also cons.
The type of accounting you choose could define the success of your business. For example, you get a truer picture of your finances and of any arising opportunities by using accrual accounting.
Let’s take a deep dive into accrual accounting now.
What is accrual accounting?
Accounting can be confusing, so here is accrual accounting explained in simple language:
With accrual accounting, revenue is accounted for at the point when it’s earned. Expenses are accounted for when they’re incurred.
It doesn’t matter if money has actually changed hands or not. We just assume it will at some future date. And this is the key difference compared to cash accounting.
The accrual method emphasizes the value of accounting as a periodic process, and that period can be the tax year. Here’s how the IRS defines accrual method accounting:
Under an accrual method of accounting, you generally report income in the year earned and deduct or capitalize expenses in the year incurred. The purpose of an accrual method of accounting is to match income and expenses in the correct year.
The result is that managers are given clearer insight into their business. Expenses are linked explicitly to income within the same period, something known as the matching principle, which is a key component of the Generally Accepted Accounting Principles (GAAP).
The alternative to accrual method accounting, cash accounting, can mean that expenses and income are separated by months when it comes to your accounting. This makes it hard to discover what’s going on, and can make businesses appear to be healthier than they are because the liabilities like credit are difficult to see.
Here are some accrual accounting examples that show how to do accrual accounting.
Accounts payable: Expenses example for accrual accounting
Smith & Co buys $1,000 of raw materials from a supplier.
Once the goods have arrived, the accounting department record the expense in the accounting. They do this even though they haven’t paid the bill yet because their supplier allows terms of 30 days.
The $1,000 debt is recorded as a liability in the company accounts.
Here’s what the IRS says about expenses under the accrual method of accounting:
[…] you generally deduct or capitalize a business expense when both the following apply.
- The all-events test has been met. The test has been met when:
- All events have occurred that fix the fact of liability, and
- The liability can be determined with reasonable accuracy.
- Economic performance has occurred.
Economic performance has a specific and somewhat complicated meaning (as explained within IRS Publication 538) but it’s enough to know that, in relation to goods or services, it’s when the goods or services are provided.
Certain recurring expenses have a special rule. Continuing the example above, if the widgets are a recurring expense then you might be able account for them in a tax year even if “economic performance” hasn’t occurred in that year.
Accounts receivable: Revenue example for accrual accounting
Smith & Co uses the raw materials to create widgets, which it sells for $3,000 to another company.
The finance team uses the date of the sale to record the $3,000 in the accounts receivable part of the accounting software.
The $3,000 sale is recorded as an asset in the company accounts.
Officially, the IRS describes revenue for accrual method accounting in the following way:
“[…] you generally include an amount in your gross income for the tax year in which all events that fix your right to receive the income have occurred and you can determine the amount with reasonable accuracy.”
The finance team record the amount in the accounting even if they know the terms agreed with the customer mean the business will not receive the $3,000 payment until the next financial period (e.g. next month).
This remains true even if the sale and receiving of the amount fall across a tax year.
Should my business use accrual accounting?
Whether you should use cash or accrual method-based accounting depends on your business.
A key factor is whether your business carries inventories, which is to say, the production, purchase or sale of merchandise produces income for you.
The fact that you must take inventories into account at the beginning and end of the tax year means accrual accounting should be used.
Cash accounting might sound like a simpler option, and it certainly is for smaller businesses (e.g. sole proprietors). But it can only be used by businesses that pass the Gross Receipts Test. This rule is set by the IRS, as follows:
“A corporation or a partnership meets the test if its average annual gross receipts for the 3 preceding tax years were $25 million or less (indexed for inflation)”
Note that this $25M threshold is relatively new. It was increased from $10M in 2018 with the passage of Public Law 115-97 (the Tax Cut and Jobs Act).
If you fail the Gross Receipts Test then you must switch to accrual method accounting. This is a legal requirement. You must do so in the tax year in which you fail to meet the test and must tell the IRS via Form 3115.
How to use accrual accounting effectively
Accrual method accounting is the only effective choice for businesses once they get above a certain level of complexity. Often this is related to business size, but not always, and it’s wrong to believe that smaller businesses should always use cash accounting.
Typically, this level of complexity might be when you employ additional staff, such as salespeople who work on commission that’s paid periodically.
Accrual method accounting might be necessary when your product or service offerings increase, and you find yourself with multiple expenses that need to be accounted for and matched to the revenue they generate. This is especially true if you start to purchase large quantities of items.
Accrual method accounting also enables you to better deal with bad debts, which can use useful if your business is exposed to variable customers whose integrity you can’t always discover in advance. Accrual method allows the use of bad debt reserve accounting to help cushion against non-payments, for example, providing greater clarity into this kind of liability than you might get with cash accounting.
Conclusion: Why use accrual accounting?
If your business is aiming for growth, and most are, then accrual method accounting is something you’re going to have to adopt sooner rather than later. Starting on the best foot therefore makes sense.
Arguably, cash method accounting should only be used by businesses that aim to stay at a certain level. A good example is a sole proprietor that offers a local service and has the goal of providing themselves with an independent income. For such a person, who doesn’t want to get bogged down in any admin, cash method is perfect.
For everybody else, accrual method accounting is simply the norm. Furthermore, it’s a basic expectation that potential investors will need to see. Not only does it provide the level of financial insight they need, but it also shows that you’re taking your accounting and admin seriously. And remember, they’re investing in you and your team, as much as they’re investing in the business you’ve created.
Accrual method accounting is tricky to learn at first. Speak to a CPA or other accountant if you need help. But once you’ve learned the basics, things slide into place pretty quickly. Consider the time spent learning as an investment in the success of your business.