When you’re running a business, keeping your books doesn’t just keep you safe with the IRS, it’s about understanding the financial story behind your numbers.
Instead of focusing solely on when your money moves in or out of your bank account, accrual accounting focuses on when income is earned and when expenses are incurred.
Sure, it might be a little bit more work, but for many businesses it’s worth the time.
What is Accrual Accounting?
Accrual accounting is a method of recording business transactions that match revenue to the time it was earned and expenses to the time they were incurred. This is different from cash accounting because they’re recorded the moment the cash actually moves.
Example:
You completed a $3,000 consultation project on November 28th and sent an invoice the same day.
If your client pays on December 15th, you will still record the $3,000 in November because that’s when you earned it.
The same goes for expenses; if you get a bill in December for services provided in November, you record the expense in November.
Why Accrual Accounting Matters
Most of the time small business owners start with cash accounting as it takes less complexity and time to utilize. However, accrual accounting has some big advantages in comparison.
A More Accurate Picture of Profitability
You can see whether a month was truly profitable or not. Rather than simply examining if you received income, this shows you the bigger picture.
Better Planning and Forecasting
Accrual accounting lets you anticipate future expenses and revenue, which helps you in the long run.
Clearer View of Receivables and Payables
You’ll always know who owes you money, and who you owe money.
Required in Some Cases
The IRS requires accrual if you carry inventory or meet specific revenue thresholds.
How it Works in the Real World
For example, let’s go through a possible scenario for a landscaping business.
In April, you sign a seasonal maintenance contract worth $12,000, payable in monthly installments from May through October. If you work under a cash accounting system, you might be tempted to record each payment as it comes in, which can make your income fluctuate wildly from month to month.
However, under accrual accounting, you don’t recognize the entire $12,000 in May just because the agreement starts. Instead, you record $2,000 each month as you perform the work.
This approach allows your revenue to line up with the services provided; not just when you happen to get paid. Over time, this creates a realistic monthly income statement, which is especially helpful when planning your expenses or perhaps applying for financing.
Benefits vs. Drawbacks in Small Businesses
Just like any accounting method, accrual accounting has both advantages and disadvantages for small business owners.
Benefits:
- Gives lenders and investors a reliable financial picture. Because it shows all income earned and expenses incurred, accrual accounting paints a truer picture of profitability than cash accounting can. This specific level of detail builds credibility with banks, investors, and potential buyers.
- Helps avoid “profit surprises” caused by payment delays. Even if your clients pay later than expected, you already have that income on the books. This helps you better plan ahead and spot trends before they become problems.
- Complies with GAAP (Generally Accepted Accounting Principles). If you need to potentially prepare audited statements or meet industry standards, you’ll be ready to set it up without overwhelming your current system.
Drawbacks:
- More complex bookkeeping process. Accrual accounting requires tracking receivables, payables, and sometimes deferred revenues which can be intimidating for those new to business finance.
- Can require accounting software or professional assistance. While you can complete it manually, most businesses rely on software or a professional to manage accrual records accurately.
- Your books may look profitable even if cash is tight. Because accrual focuses on when income is earned, not when collected, you may show a profit on paper while you are awaiting payment.
Getting Started with Accrual Accounting
If you’re thinking of making the switch from cash to accrual accounting, the best practice we recommend is planning ahead. There are a few things to consider before making the official switch.
- Choose the Right Software. Most Modern accounting tools (such as QuickBooks, Xero, and Wave) have accrual options built in, making it easier to handle transactions.
- Get Organized. Keep detailed records of invoices, bills, and contracts. In accrual accounting, these documents are the backbone of your entire system. This ensures that you record revenue and expenses in the correct periods.
- Consider Hiring a Professional. A bookkeeper or accountant can help you set up your chart of accounts, enter opening balances, and give tips on day-to-day processes. This can save you from making expensive mistakes down the road.
- Time the Switch . The easiest time to move to accrual is at the start of a new tax year. Doing that keeps your books clean and helps you avoid organizing records within 2 accounting methods.
Making the Best Switch For You
Owning a business is stressful enough on its own, and confusing financials shouldn’t add to the chaos. The method you choose depends on the size and nature of your business. If your company is inventory heavy or perhaps you’re looking into obtaining investors or buyers, adopting this method will ensure that the numbers are squared away correctly.
Leave a Reply