What Is Accrual Accounting?
Most businesses use one of two main accounting methods to keep their books in order: accrual accounting and cash accounting. If you use the accrual method, you record financial transactions when they occur, not when money actually leaves or enters your account. With cash accounting, the opposite is true: you won't create a journal entry for your financial transactions until the cash has actually been deposited in or removed from a bank account.
For most businesses, accrual-based accounting is more accurate. Want to know how and why? Keep reading—we have the answers.
How does accrual accounting work?
Let's say you wrap up a project for a client at the end of January. You send off the invoice immediately, but the client takes a few weeks to pay their bill, so the money doesn't arrive in your account until mid-February. So when do you add the financial transaction to your books—January or February?
Well, with accrual-basis accounting, you'd record the full amount of the financial transaction as soon as you finish the project and send the invoice; in this scenario, the answer is January.
Another way to think about it? With accrual-basis accounting, you record income when it's earned, not right when you receive it, and expenses when they're billed, not right when you pay them.
What benefits does accrual accounting offer?
Between cash- and accrual-basis accounting, accrual wins hands down as the most accurate, helpful accounting method.
Most notably, the accrual method paints a better long-term picture of business trends and growth than the cash method. If your construction business gets most of its contracts in the spring and summer, you might not be paid the full amount until fall, but fall isn't actually when you did most of your business—and your books need to reflect that. Otherwise, it's hard to accurately project growth, allocate next year's budget, and make long-term financial decisions.
Plus, the IRS (Internal Revenue Service) requires that businesses making over $5 million use the accrual method. If your business starts out making under $5 million but eventually grows to exceed that mark (hooray!), you'll have to switch accounting methods, which is, trust us, an absolute mess.
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Are there drawbacks to accrual-based accounting?
Remember the adage about counting your chickens before they've hatched? If you don't keep a close eye on both your accrual-based books and your actual cash flow, you can end up spending money you don't have—which can land your business in the red in no time flat.
To make sure you aren't overspending, you need thorough accrual-based books and accurate, closely watched cash flow statements, which show you how much cash is flowing into and out of your business in a given time frame.
In other words, accrual-based accounting is much more complex than cash based. That isn't to say it's beyond the grasp of most small-business owners—just that there's a learning curve, and it can feel a little steep for the non-accountants among us.
Another risk? You might end up paying income taxes on income you haven't received yet. For instance, if you use the accrual-based system and sent a client an invoice in December 2019, you should have recorded the income that month. The income taxes you pay will be part of the 2019 tax year—even though you won't receive the income itself until 2020.
This also means that even though your bank account will show an increase when you get paid in 2020, you don't need to pay income tax on that cash received once April 2021 rolls around; you already did!
If this all sounds a little hard to keep track of, you're not wrong. The IRS's guide to accrual and cash accounting can help you understand the basics, but working with an accountant to file your business taxes is the best way to minimize confusion about income tax payments.
Does accounting software use accrual accounting?
Here's another reason to try accrual-basis accounting: most accounting software defaults to accrual-basis rather than cash-basis accounting.
However, while software providers like QuickBooks and Xero automatically generate accrual-basis journal entries and reports, you can choose to generate cash-basis reports instead. Patriot Software also lets you toggle between the two types of accounting. So if you're committed to cash-basis for now, accounting software won't leave you out in the cold.
In general, accountants prefer the accrual basis too—but not always. For instance, while most of our favorite outsourced accounting services offer both the accrual and cash methods, some, like Merritt Bookkeeping, notably offer cash basis only.
Accrual-basis accounting is a secure, accurate way to log business transactions and keep tabs on income and expenses. Of course, if your business makes under $5 million a year or you're an individual freelancer with a handful of small yearly projects, cash-basis could work for you. Otherwise, we say stick with accrual.
Want to learn more about how to read your business's finances? Check out our page on the most important financial statements for your small business, including cash flow statements, balance sheets, and income statements.
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