By 2025, 50% of governments will use accrual basis accounting to report financials, according to data from the International Federation of Accountants. The shift among governments to this method of accounting has been continuous since 2018, when the figure was only 24%.
Why are governments switching to the accrual basis of accounting? According to the IFAC, it’s easier to understand the financial health of an entity with accrual accounting, compared to cash basis accounting.
What makes sense for governments also makes sense for many businesses. Imagine your business orders raw materials and other goods on credit. If you don’t account for the expenditures until the invoices come due or you actually pay them, you may have a skewed sense of where your business stands, financially.
Accrual provides a comprehensive overview that improves transparency and trust with external parties and provides an opportunity for internal analyses, such as comparing revenue cycles to cash flow cycles, monitoring ongoing debt obligations, or determining the seasonality of specific product lines.
Accrual basis accounting ensures entrepreneurs, small businesses, and large enterprises alike understand their financial positions more accurately at all times.
What Is Accrual Accounting?
Accrual accounting is a method of accounting, which dictates that revenue and expenditures are recorded when they occur; not when money is exchanged. For example, with this method, businesses record revenue when the sale occurs, not when the client makes payment.
Outflows and other business transactions are treated the same way. If the business buys goods based on a net 30 invoice, for instance, the expense is accounted for when the goods are received — not up to 30 days later when the invoice is paid.
How Does Accrual Basis Accounting Work?
Accrual basis accounting works for accounts receivable and accounts payable and involves a system of double-entry accounting. This means that every transaction involves multiple ledger or journal entries to ensure the books remain balanced and a clear financial picture can be seen on balance sheets and other financial reports.
To understand how the accrual method works, let’s consider two examples. First, we'll look at how revenue is recorded in accrual accounting. Then we'll look at how this method handles expenses, such as when a business purchases goods or services.
If you aren’t familiar with journal entries or double-entry accounting, you may want to review our article on double-entry accounting before continuing.
Accrual Accounting for Revenue
Pete’s Tire World lands an account with Truckers, a business that has a fleet of vehicles. The business negotiates the following deal: Pete’s Tire World will supply tires to Truckers upon request. It will invoice Truckers on the first of the month for all tires provided the previous month, and Truckers has net 15 terms.
Truckers ordered $2,000 in tires on March 19. Pete’s Tire World sends an invoice for $2,000 on April 1. The business pays the invoice on April 10.
On March 19, when Truckers orders the tires, the revenue is realized. The accounting department makes the following journal entries:
- A $2,000 debit to accounts receivable, specifically the Trucker’s account
- A $2,000 credit to revenue
On April 1, no journal entries are made. Though the invoice has only now been sent, the revenue was realized on March 19, when the sale took place.
On April 10, when the business pays its invoice, the accounting department makes new journal entries to update the financial statements:
- A $2,000 credit to accounts receivable (the Trucker’s account), as the money has been received and is no longer AR
- A $2,000 debit to cash
If Pete’s Tire World was operating on the cash-basis of accounting, they would recognize revenue from this sale in Q2 (assuming their fiscal year matches up to a calendar year), as the payment came in April.
While operating on the accrual basis of accounting, this revenue lives in Q1, as the sale was made in March. This distinction helps a business differentiate between when they are making money and when they are collecting money.
Accrual Accounting for Expenses
The method is similar when money is flowing in the other direction. Let’s consider an example where Pete’s Tire World is the business incurring the expense. In this case, one of its tire delivery trucks breaks down and the cost to fix it is $1,500.
The shop fixed the truck and invoiced Pete’s Tire World on May 20. Pete’s pays the invoice on June 2.
Pete’s Tire World’s accounting team must make the following accrual accounting journal entries on May 20:
- A $1,500 debit to a repair and maintenance expense account
- A $1,500 credit to accounts payable
On June 2, when the invoice is settled, the following journal entries are recorded:
- A $1,500 debit from accounts payable, as the $1,500 is no longer outstanding
- A $1,500 credit to cash that offsets the previous debit
Cash Basis Accounting vs. the Accrual Method of Accounting
Of course, we have to discuss the other primary bookkeeping method: the cash basis method. While it doesn’t offer the same transparency and overall accurate financial picture as accrual accounting, cash accounting can be simpler. As such, it’s often the choice for sole proprietors, freelance contractors, and very small businesses with limited operators, investors, and debtors.
What Is the Cash Basis of Accounting and How Does It Work?
Despite its name, cash accounting doesn’t have anything to do with whether or not a business accepts or prefers cash payments. It refers to when revenue and expenses are recorded and how journal entries for those items are made.
The key difference between accrual and cash basis accounting is that with cash accounting, transactions aren’t recorded until the money actually transfers. Because of this, cash accounting doesn’t use the same double-entry method that accrual accounting does.
Let’s revisit Pete’s Tire World and say that Pete’s sold $3,000 in tires on March 15. The customer didn’t pay for the tires until April 10. If it was using cash basis accounting, Pete’s wouldn’t recognize any revenue until April 10.
Instead, the accounting entries would include:
- A debit of $3,000 indicating Pete’s was owed money on March 15
- A credit of $3,000 indicating the invoice was paid on April 10
As opposed to the accrual method, revenue would be recognized in Q2.
Main Differences Between Cash and Accrual Accounting
|Accrual Basis Accounting||Cash Basis Accounting|
|Revenue recognized when good exchange hands||Revenue recognized when cash/payment exchanges hands|
|Uses a double-entry system of accounting||Doesn't use a double-entry system of accounting|
|Preferred by Generally Accepted Accounting Principles (GAAP)||Not preferred by GAAP|
|Must be used by most corporations and midsize or larger businesses||Can be used by contractors, solopreneurs, and small businesses with less than $25 million in annual gross receipts within the previous 3 years.|
Advantages of Accrual Basis of Accounting
You might think cash accounting makes financial statements easier to handle, but there are numerous reasons to choose accrual accounting instead. We've gathered a list of benefits of this method:
- Accrual basis accounting is allowed by Generally Accepted Accounting Principles, or GAAP. Cash accounting isn't. These accounting standards may matter to investors, lenders, and others. If you plan to grow your business in a material way, seek an eventual IPO, or otherwise partner with investors in the future, accrual basis accounting serves you better than cash accounting.
- You might be required to use accrual accounting by the IRS. As noted in the table above, only small business taxpayers that fall within certain revenue thresholds can opt for cash basis accounting.
- Accrual accounting helps support more accurate financial reports. Taking the steps to record revenue and expenses when they occur allows business leaders and financial decision-makers to better understand a company's expected income and debt situation.
- Increased accuracy makes strategic planning easier. When you can see expected future cash flow and understand, in real-time, where your business stands with respect to debts and income, you can make more realistic plans for growth.
Of course, the accrual method of accounting does have some downsides. Primarily, it's a bit more time-consuming and challenging than the simpler cash basis accounting. For this reason, it's important to work with CPAs or other professionals and invest in the right accounting software, which can automate a lot of journal entry and reversal work.
You also need to ensure you understand your books when reviewing them. While accrual accounting is a GAAP best practice and certainly helps order the puzzle pieces correctly, inadequate oversight and lack of controls can leave any business at risk for fraud or costly mistakes.
Is Accrual Accounting Right for Your Business?
If you're a business owner of any size who wants a more accurate picture of your company's financial health, the accrual method of accounting might be right for you. If you're a large organization or a growing startup planning to seek outside funding, accrual accounting may be a must for tax purposes or to ensure you get access to the financial opportunities you want. Plus, if you had more than $25 million in gross receipts within the past three years, you may not have a choice.
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