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You might have heard or read the terms “accrual basis” and “cash basis” in regards to accounting. If you ask three accountants which basis you should use for your business, you are likely to get three different answers. This is because each basis is used for different purposes, and the accountant’s answer will be colored by their perspective of how you should be using your financial statements.
Both accrual basis accounting and cash basis accounting have benefits and drawbacks. In this article, we’ll take a look at the accrual basis of accounting, including what it is, when you should use it, and what you need to know about this powerful accounting method.
Accrual basis accounting recognizes revenue and expenses when they are incurred. And while that might seem easy to understand, there is much more to accrual basis accounting than first meets the eye.
Accrual basis accounting is used for both the matching principle and the revenue recognition principles of accounting. The matching principle states sales and the expenses used to produce those sales are reported in the same accounting period. These expenses can include wages, sales commissions, certain overhead costs, etc. Similarly, the revenue recognition principle states revenue is reported when it’s earned, regardless of when payment for the product or service is actually received.
In other words, in accrual basis accounting, when the money is actually received is irrelevant. Accrual basis accounting recognizes income and expenses when they are actually incurred.
Let’s say you do work for your client in May of this year. You use a subcontractor to do part of the work, and you purchase a piece of software which you will pass on in an invoice to the client.
You purchase the software for your client on May 16, and you put that purchase on your credit card. Your subcontractor finishes his work on May 20 and issues a bill on that same date. Finally, you invoice your client on May 31.
Because of cash flow issues on your client’s end, they wait until August 13 to pay your invoice. But the following happened between the time you invoiced your client and the time they paid you:
Now that your client has paid you, you:
That’s a lot of dates floating around over the course of five months. But here’s the important thing: In accrual basis accounting, all of the income and expense activity actually happened in May. You did the work for the client in May, you incurred the expenses for the software and the subcontractor in May, and you invoiced your client in May. When you received the payment from your client—and when you paid the expenses you incurred providing the services for the client—is irrelevant.
A lot of business owners disagree with the matching and revenue recognition principles of accrual basis accounting. After all, what really matters to most business owners is when the money enters and leaves their businesses.
Cash flow is critical to small businesses, and, unfortunately, cash flow issues often result in the failure of businesses that are “profitable on paper.” From this perspective, cash basis accounting seems much more relevant than accrual basis accounting to many business owners.
However, there is a lot of power in accrual basis accounting. Because you can match your revenue and your expenses to when they actually occurred in your business, you can get a clear picture of the profitability of your business on a month-to-month basis.
Let’s look back at our plain English example above. If you didn’t use accrual basis accounting, you would see all your income for the work you did for the client in August—when they (finally) paid you—but you would have expenses for that work in June, July, August, and September. This would make it very cumbersome, if not downright impossible, to get a good picture of your profitability for five months. And although you could use subsidiary reports in your accounting software to see the profitability for the work you did for this particular client, those reports would still not show you the whole picture as it relates to your overall business profitability.
There are two clear indicators you should use accrual basis accounting. If you extend credit to your customers by extending payment terms on your invoices or if you are billed by suppliers or vendors and they extend payment terms to you, you should use accrual basis accounting.
When you extend credit to your customers, you will enter a transaction to accounts receivable in your business’s accounting software. When your suppliers or vendors extend credit to you, you will enter a transaction to accounts payable in your business’s accounting software.
In other words, if you use accounts receivable or accounts payable in your business, you should use accrual basis accounting. Accounts receivable (A/R) and accounts payable (A/P) won’t show up on cash basis financial statements, and so you will get an incomplete picture of your business’s financial standing if you have A/R and A/P but don’t use accrual basis accounting.
We could argue that all businesses should use accrual basis accounting. After all, accrual basis accounting gives you a true picture of the profitability of your business, regardless of when cash enters or leaves your business.
Let’s look at another example. Let’s say you operate a retail business, and you don’t extend credit to your customers. This eliminates the possibility of customers waiting months to pay you. Let’s also assume all the expenses in your business are paid as they are incurred—inventory is paid for when it’s delivered, and all operating expenses are paid through automatic payments.
In other words, you don’t have accounts receivable or accounts payable, both key indicators that a business needs to use the accrual basis of accounting.
However, let’s say you purchase an annual membership to a retailer’s association, and this membership costs $2,400/year. You pay this membership each December for the following year, because your cash flow is robust due to the holiday season.
When you look at your financial statements for December, your profit and loss statement will reflect the $2,400 membership payment. This makes sense from a cash flow perspective—after all, this is when you paid for the membership. But the membership is for the following year, and you will use it over the course of the year.
Under the matching principle, you are effectively “using” $200 of this expense in each month of the following year. Accrual basis accounting would reflect this in the following manner:
This might sound like more trouble than it’s worth, but the adjusting entry can be easily automated in most accounting software, so it only has to be set up once. The benefit of making this additional effort is you will be able to easily see how your expenses play out over the course of the year in your financial statements, rather than having to create a spreadsheet or otherwise manually track the expense.
Most small businesses in the United States are cash basis taxpayers, meaning they only pay taxes on money that has actually entered their business, less expenses they paid, during the course of the year. If you are a cash basis taxpayer—and chances are very good you are—then you will need to use cash basis financial statements instead of accrual basis statements to prepare your tax returns. And if you accrue expenses as in the example above, you will need to make an adjustment to recognize the entire expense when you paid it before preparing your tax return.
If you don’t prepare your tax return yourself, your accountant can make any adjustments necessary to account for accruals on your books prior to preparing your tax return.
Your tax basis should not be the sole determining factor of whether you keep your books on a cash or accrual basis. You use your financial statements to run your business 365 days a year and for taxes one day each year. Making sure your financial statements give you the most accurate view of your business possible will help you make sound financial decisions.
Accrual basis accounting provides a clear picture of how your business is performing regardless of when the cash flows in and out of your business. Accrual basis accounting takes a bit more effort, but the clarity it gives you in your business is worth the additional effort.
Your accountant will likely tell you they need cash basis financial statements to prepare your tax return. This shouldn’t deter you from keeping your books on an accrual basis. Most software packages make it easy to produce cash basis financial statements from accrual basis books with just a click of a button, and your accountant is well versed in how to manually adjust financial statements from accrual to cash basis if necessary.
The one thing an accrual basis profit and loss statement does not provide is a clear picture of cash flow in your business. To get this information, you will need to produce a statement of cash flows—the financial statement that reconciles your accrual basis profit and loss statement to the cash on hand in your business. The cash flow statement isn’t inherently easy to understand, but your bookkeeper or accountant can help you understand it and what it means for your business.
Now that you understand more about accrual basis accounting, speak with your bookkeeper or accountant about how you can leverage this powerful accounting method to help you make more informed business decisions. They will be happy to help you understand how you can use the information in your accrual basis statements to increase your business’s growth and profitability.