Accounting 101 for Small Businesses

Understanding the Basics of Accrual Accounting

Has your business reached the point where you’re ready to hire your first employee or expand into new customer markets? If you’re currently using cash accounting to report business expenses and income, it may be time to revisit whether the accrual method of accounting will be more effective for your financial and tax reporting.

In accrual accounting, you record income when you complete a service or when goods are shipped and delivered. Although most small businesses, particularly sole proprietorships and partnerships, use the cash method, the IRS states, “If an inventory is necessary to account for your income, you must generally use an accrual method of accounting for sales and purchases.”

The inventories rule generally applies to businesses that gross receipts over $1 million per year. Certain organizations grossing sales over $5 million are also required to use accrual accounting to report business income and expenses.

If your business falls under these rules, or if you’re simply debating whether the accrual method is right for your business, read on for an overview on some of the benefits and drawbacks of accrual accounting.

How Accrual Accounting Works

Unlike cash accounting, where income is recorded when cash payments (these can also be credit-card receipts, checks or other forms of payment) are received from customers and expenses are recorded when cash is paid to vendors, accrual accounting focuses on when income is earned and expenses are incurred. Consequently, all transactions are recorded regardless of when cash exchanges hands.

For example, if you sell merchandise to a customer on store credit during the month of October, the accrual method dictates that you record the transaction immediately as an item in accounts receivable until you receive payment. Even if the customer doesn’t make a cash payment on the merchandise until December, the transaction should be recorded as income for the month of October.

The same applies to any goods or services you buy on credit. Supplies purchased on credit in April are recorded as expenses for the month of April under the accrual method, even if you don’t make a cash payment on those supplies until May. Thus, business expenses are recorded when you receive products and services, even if you haven’t yet paid for these items or if they’re for future use.

According to the IRS, companies can use either the cash method or accrual method to figure taxable income and keep their books for the tax year. However, certain businesses that produce, purchase or sell merchandise, or that earn gross sales over $5 million, must use the accrual method in their accounting.

For more information on exceptions to these rules and other restrictions, review IRS Publication 334: Accounting Periods and Methods.

Advantages of the Accrual Accounting

Recording cash transactions based on when services are completed, products are delivered and expenses are incurred can provide a more accurate view of your business’ performance.

Here are the main advantages typically associated with accrual accounting.

Accrual accounting matches income with related expenses

One of the main benefits of accrual accounting is that it more accurately captures business activity and profitability compared to cash accounting. Accrual accounting is particularly helpful for measuring profitability during a specific month or tax year if your company bills customers at a later date for services already performed, or if it sells products to customers on store credit. The same applies to expenses like insurance premiums, which are paid upfront but used at a later date.

Take the following example:

  1. Your company spends $500 organizing an event in November, but doesn’t receive the $1,000 payment for that event until February.
  2. Using the accrual method, your income statement will now show $1,000 of revenues in November.
  3. Additionally, the $1,000 will also be reflected as an accounts receivable item on your November balance sheet.
  4. Finally, the estimated true profit of $500 for the service delivered will be added to your owner’s equity or retained earnings.

Despite the time lag between the delivery of services and receipt of payment, the event’s expenses are matched with the event’s revenues irrespective of when the customer actually pays.

Accrual accounting can defer your tax liability

Both cash accounting and accrual accounting can offer flexibility around tax planning. In the case of accrual accounting, if you receive an advance payment in 2015 for services that you agree to perform by the end of the following year, you can delay paying taxes on that income until the next tax year.

See IRS guidelines on how to report advance payment for services using the accrual accounting method.

Disadvantages of Accrual Accounting

Whereas accrual accounting’s strengths lie in accurately showing business profitability and representing long-term revenues and expenses, it has a few drawbacks as well.

Here are some pitfalls of accrual accounting to keep in mind if you’re contemplating transitioning from the cash method.

Accrual accounting ignores cash flows

Under the accrual accounting method, the amount of cash coming in from your sales may not always match up with the revenues you’re reporting on your books. In other words, even if your income statement shows thousands of dollars in sales, your actual bank account may show a smaller balance if customers haven’t paid what they owe you. As a result, accrual accounting does a poor job of tracking cash flows.

Accrual accounting requires more bookkeeping and staff resources

Due to the added complexity and paperwork required under the accrual method of accounting, it tends to be viewed by small business owners as more complicated and expensive to implement. Because you record revenues before you actually see the cash, you’ll need to track your cash flow separately under the accrual method to ensure you can cover your bills from month to month.

One way to offset the people and time resources required under accrual accounting is to invest in automation tools and software, such as QuickBooks.

Using the Accrual Method for Your Business

According to the Financial Accounting Standards Board (FASB), “Accrual accounting goes beyond cash transactions to provide information about assets, liabilities and earnings.” In other words, accrual accounting provides a better picture of your overall financial position. Since the accrual method conforms to GAAP, the set of guidelines and rules used to prepare and standardize the financial reports of both public and private companies in the U.S., accrual accounting is widely considered to be the standard (and oftentimes more accurate) accounting method for most companies.

If you’re contemplating moving your organization from cash accounting to accrual accounting, or to a hybrid method that combines cash, accrual and special methods of accounting, refer to IRS Publication 538 and Form 3115 for further guidance.

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Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.