As your business grew, one of your friends suggested it might be time to switch to accrual accounting. But what if you’re not entirely sure what it is?
In this article, I’ll cover the fundamentals of the accrual method, how it works, and its pros and cons compared to the cash method to help you make the right decision.
And if you’re looking to make friends with your accountant (for reasons best known to you), understanding accruals would give you that chance.
Table of contents
Methods of accounting
There are two main accounting methods: cash accounting and accrual accounting.
Before we explore the accrual concept, let’s start with the easier of the two.
Cash accounting
The cash basis of accounting is straightforward: you recognise revenue when you receive cash and record expenses when cash is paid out. It perfectly aligns with your bank account statement.
In the early stages, many small businesses prefer cash accounting. When business transactions are basic and infrequent, this approach is practical and helps to track cash flow.
You might get away with the cash method initially. Still, the timing effect can complicate things quickly as the business expands. For instance, you’ll have to keep track of various due dates on outstanding invoices when analysing financial performance. Or you might reach a regulatory threshold requiring you to switch to the accrual method.
Accrual accounting
In contrast, the accrual basis of accounting recognises revenue when it’s earned and expenses when they’re incurred — which doesn’t necessarily align with actual cash movements.
This is the key difference from the cash method.
Accrual accounting is generally the preferred method because it reflects a more accurate picture of a company’s operations.
It accounts for all revenue and expense transactions, making it particularly useful for assessing financial performance at a specific point in time. It makes budgeting and planning processes simpler.
And there’s also a blend of these two methods called the hybrid method. Although less common, it provides flexibility for certain businesses.
‘Accruals’ in plain language
So once again, what exactly is an ‘accrual’? Think of it as a reflection of promises received (accrued revenue) and promises made (accrued expense).
Accrual accounting is based on two accounting principles: the matching principle and the revenue recognition principle.
- The matching principle states that expenses should be recognised in the same period as the revenue they help generate.
- The revenue recognition principle states that revenue should be recognised only when it’s earned. Generally speaking, revenue can be recognised when the risk and control of goods have been transferred to the buyer.
Accrued revenue
This means if you’ve delivered goods or services to the buyer, but the buyer has not yet transferred cash, you’ll need to accrue this revenue. According to the revenue recognition principle, you’ve already earned this revenue even though the payment has yet to be made.
Consider an example:
Suppose you’re a lawyer who has provided legal services and billed a client $1,500. You issued an invoice today with a payment term of 30 days, but the client hasn’t paid yet.
- Under the cash method — today, you wouldn’t recognise any revenue.
- Under the accrual method — today, you would recognise revenue of $1,500.
Accrued expenses
Similarly, if you’ve incurred expenses — received goods or services but haven’t yet paid cash for them — these expenses should be accrued because you’re already using the goods.
Besides, according to the matching principle, these expenses should be recorded in the same period as the revenue they help to generate.
Continuing with our example:
On the same day, you incurred court filing fees of $200 for that legal work, payable within 15 days, but you still need to make the payment.
- Under the cash method — today, you wouldn’t record any expenses.
- Under the accrual method — today, you would record an expense of $200.
As you can see, the aim of accrual accounting is to match revenue and expenses to the correct periods in which they occurred, regardless of when cash transactions were made.
Note: there’s an opposite scenario to accruals known as deferrals. This occurs when you receive cash before goods are provided (unearned revenue) or pay for something before benefitting from it (prepaid expenses). A related concept is depreciation, which allocates the cost of capitalised assets over time. These topics aren’t covered in this article.
Accrual accounting: advantages and disadvantages
If you’re considering adopting the accrual method, here are the key pros and cons compared to the cash basis of accounting.
Advantages of accrual accounting
Transparency
Accrual accounting helps to reflect a more accurate financial picture, which is useful when preparing financial statements and analysing ratios, such as profit margins.
From the example above, an income statement prepared today would show a profit of $1,300 under the accrual method. On the other hand, the profit would appear to be zero using the cash method even though the activities occurred.
Easier to raise finance
Investors, lenders, and business appraisers prefer financial statements prepared using accrual accounting. This can lead to better opportunities to raise equity or debt financing — and at more favourable terms.
Compliant with IFRS and GAAP
Accrual accounting is the preferred method under International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) accounting standards. If a switch to the accrual method becomes mandatory, being familiar with it means you’ll need to make fewer changes.
Disadvantages of accrual accounting
More complex
The accrual method is more challenging to implement and manage. You’ll need to make estimates and assumptions about when to recognise revenue and how to match expenses with revenues.
Harder to track cash flow
The accrual method doesn’t directly provide a picture of cash flows. You’ll need to prepare separate cash flow statements to effectively monitor cash movements.
Tax implications
In the long run, both cash and accrual methods lead to similar tax outcomes. However, the accrual approach also requires accounting for taxes based on earned revenue and incurred expenses. This can make filling out tax forms trickier because the rules and paperwork are more complicated.
Summary
I hope you now have a better picture of accrual accounting and how it differs from the cash method. Choosing between the two depends on your business size, industry norms, and regulatory requirements.
Accrual accounting relies on double-entry bookkeeping, where each transaction is recorded with corresponding debits and credits. Your familiar spreadsheet likely won’t cut it, but any basic accounting software can handle this task with ease.
