Accrual accounting is used because of it's benefits
As a business owner, experiencing growth can be a double-edge sword. Why? When your business growth experiences an increase in revenue and profit your bookkeeping can get complicated. You may need to consider changing the way you handle your money.
Most small or start-up business typically set up their books using a cash accounting system. However, if your business incurs- for example - new revenue streams and expense categories along with new investment strategies, a cash method may not be adequate in handling the complexity of your business activities.
Accrual accounting: Definition
“…is an accounting method that records revenues and expenses when they are incurred, regardless of when cash is exchanged. The term "accrual" refers to any individual entry recording revenue or expense in the absence of a cash transaction.” Entrepreneur magazine
In other words, you get to count your eggs before they hatch - but you also have to go collect the eggs!
Why would a business switch to accrual methods?
Making a switch from cash basis to accrual may not be easy for some. It may mean bringing in experienced, outside help to assist with the transition or verify changes for accuracy. However, there are 5 simple reasons experts say accrual could be right for you:
1. Improving your Financial Picture
“Accrual accounting easily allows the business owner to see at a glance if the company is profitable, where the profit is coming from, and where expenses are going. Accrual accounting also matches revenues with the expenses the company incurred to produce it.”
2. Staying GAAP Compliant
In the United States, GAAP (generally accepted accounting principles) is considered the industry standard for preparing financial statements. In fact, companies in the United States with $5 million dollars in annual sales or $1 million dollars in annual inventory sales are legally required to use the accrual accounting method as part of GAAP in order to report their financial information and for income tax preparation. Meeting GAAP allows a company’s financial picture to be easily accessed by investors and other financial institutions.
3. Improving Accuracy
Accrual accounting gives companies a truer depiction of their resources and financial responsibilities. This serves as a company advantage because according to Inc.com, it allows businesses to properly manage the ebb and flow of financial activity. Income and debts can be more accurately assessed with accrual accounting.
4. Planning for growth
Cash accounting is an “after the fact” accounting style, while accrual accounting is done in real time. According to World Bank, accrual accounting makes it easy for business managers to plan the future. Since they do not have to wait for cash to be received to see what their profits are, professionals can strategize ways to improve sales or generate more revenue as they spot financial plateaus. This keeps a company progressive, which is crucial to viability.
5. Obtaining Credit
In order to expand, or even to survive, most businesses will depend on credit. Accrual accounting allows companies to record and measure credit – both credit owing as well as owed.
Entrepreneur magazines makes this valid point “The accrual method is required if your business's annual sales exceed $5 million and your venture is structured as a corporation. In addition, businesses with inventory must also use the accrual method. It's also highly recommended for any business that sells on credit, as it more accurately matches income and expenses during a given time period.”
Is there another method besides cash accounting?
Between the two types of accounting, it is important to note that a 3rd option exists that is an additional component - but not for every business. “The hybrid method of accounting allows your business to use any combination of cash, accrual, and special methods of accounting. Generally, the IRS allows businesses to use this method as long as it is calculated and reported consistently. However, you cannot use the hybrid method if you use cash accounting to report income or accrual accounting to report expenses. See IRS.gov for more exceptions.” SBA.gov
Be sure you are confident about the type of bookkeeping you pick to handle your business’ finances. If you have any doubts, find a local accounting group or outsourcing firm that can give you a fair assessment of your books. This can keep you in compliance with IRS guidelines and federal accounting regulations.