In accrual basis accounting, income is reported in the fiscal period it is earned, regardless of when it is received. Expenses are deducted in the fiscal period they are incurred, regardless of when they are paid. In other words, you record both revenues—accounts receivable—and expenses—accounts payable—when they occur.
Accrual Basis Accounting vs. Cash Basis Accounting
The difference between the two types of accounting is when revenues and expenses are recorded. In cash basis accounting, revenue is recorded when cash is received, and expenses are recorded when they are paid, regardless of when they were invoiced. To illustrate the difference between the two accounting methods take the example where a business sells a product and the customer pays by credit:
- Using accrual basis accounting, the revenue is recorded immediately.
- Using cash basis accounting, the revenue would not be recorded until the credit payment was received.
Similarly, if a business incurs an expense and pays by credit, in accrual accounting the expense is recorded immediately, rather than deferred until the credit payment is received under cash basis accounting.
Accrual basis accounting gives the most accurate picture of the financial state of your business.
The advantage of cash-based accounting is simplicity. It is much easier to manage cash flow in real-time by merely checking the bank balance rather than having to examine accounts receivable and accounts payable. Given that most businesses fail due to improper management of cash flow, businesses that use accrual accounting still need to perform cash flow analysis.
Revenue is recorded when payment is received.
Cash flow is managed in real time.
Provides a point-in-time picture of a business's cash flow.
Revenue is recorded immediately.
Cash flow is managed by checking accounts receivable against accounts payable.
Gives a more accurate picture of the longer-term state of a business.
The Advantages of Accrual Accounting
While cash-based accounting can give a point-in-time picture of the business cash flow, accrual-based accounting offers a more accurate picture of the longer-term state of the business; revenues and expenses are immediately recorded, allowing the business to more properly analyze trends and manage finances.
Accrual accounting makes it easier to match revenues with expenses. For example, if as a contractor you paid for $5,000 in construction materials for a project in December, finished the job in the same month, but did not receive payment until the following February, using cash accounting, your books would show a large loss for the period ending in December but a large profit for the following period that includes February. With accrual accounting, you would book the revenue from the job in December, the same month that you paid for the construction materials.
Tax Implications of Accrual vs. Cash Accounting
Whether your business uses accrual or cash accounting can have a significant effect on taxation. For example, if your fiscal year is the end of December and your business invoices a customer for $10,000 in November of the current year but does not receive payment until January of the following year, under the accrual method, the $10,000 would be included as revenue in the current taxation year; whereas using the cash method, the $10,000 would be included in the following year.
Which Method Should Your Business Use?
Many sole proprietorships and small businesses use cash basis accounting; however, accrual basis accounting is the method of accounting most businesses and professionals are required to use by law in the United States and Canada.
In general, if your business carries inventory and sells merchandise, you will be required to use the accrual method as will any business that extends credit to customers, as cash accounting has no facility to track customer monies owed on an account.
Most incorporated businesses use the accrual method. Public companies that trade shares on stock exchanges are required to follow generally accepted accounting principles (GAAP), which require accrual-based accounting, as investors want the most accurate picture possible of the state of a company's finances. If in doubt, check with your accountant as to which method you should use.