Why Accrual Basis Accounting Rules Small Businesses?

When you start a small business, you’ll hear the terms “bookkeeping” and “accounting” almost interchangeably. Small companies may use both to keep track of business finances. Keeping a book of general records, which contains all of your company’s financial activities since its foundation, is known as bookkeeping. In contrast, accounting is examining the data in financial records to gain an understanding of your financial choices.

Accounting is often called the language of business. It involves the procedure for gathering, analyzing, and reporting financial data. As a business owner, you can learn about the resources, finances, and outcomes the company achieves through accounting. Accounting aims to create insight based on the record of the business’s financial activities. It entails the analysis of the figures generated by the bookkeeping to ascertain the company’s financial standing. Besides this, preparing tax returns and other necessary financial documents are also a part of accounting.

Every firm must record its financial transactions to calculate tax liability at the end of the year. Additionally, businesses need a single place to compile their income and expenditure data, which is necessary to file taxes. The two methods for accounting for finances are cash and accrual.

Consider that you run a company that sells technology services. The expenses and revenue recording time can significantly impact earnings from one reporting period to the next. Suppose you received complete payment as cash when the subscription started. 

Under the cash method, if you pledge $10,000 worth of technology services with a five-year subscription plan, the transaction is recorded when the client makes the initial payment and nothing for the next five years. However, with accrual accounting, to get the real picture of the transaction, the payment receivable is spread over five years until the subscription ends.

The key variation is that the accrual approach keeps track of accounts receivable and payable, which can give a more accurate picture of a company’s performance over the long run. For instance, a business may have sales in the current quarter that the cash method would not report. The subsequent quarter is when the relevant revenue and cash inflow happen, but the investors may believe a company is not profitable even while doing well. In the long run, a business is lucrative, but it may experience a small financial shortfall in the interim.

Businesses prefer accrual accounting as it is easier to distinguish between liabilities and assets. The accrual method of accounting helps to maintain up-to-date financial records and smoothens revenue flow over time. It offers a more realistic picture of a company’s health by including accounts payable and receivable.

Suppose the following business transactions happen in January 2023:

• You raised a $6,000 invoice for a graphic design project you completed in January 2023 and the client paid in the same month.
• Another client paid $1,500 for a project you invoiced in December 2022. 
• Simultaneously, you received & paid a bill for $2,000 from a developer for January 2023, and also you had to pay $150 operating costs associated with a bill from December 2022.
• The profit for January 2023 would be $4,000, which is $6,000 in revenue for the month minus $2,000 in expenses incurred. 
• The profit for December 2022 would be $1,350, which is $1,500 revenue minus $150 expenses incurred.

Since both accounting procedures are different, the tax year in which income and expenses are recorded is one of the critical distinctions between cash and accrual accounting. The accrual accounting system records money on the day an invoice is raised whereas the cash basis accounting records income when it is received. In accrual accounting, the previous month’s bill or invoice that is paid in the current month will affect the respective asset/liability.

According to accrual accounting, if you invoice a client for $1,500 in December 2022 and receive the payment in January 2023, the transaction is recorded as a part of your 2022 income, and subsequent taxes are calculated. 

On the contrary, according to cash accounting, if you invoice a client in December 2022 and receive the payment in January 2023, that transaction is recorded as a part of your 2023 income, and taxes are calculated accordingly. 

It may be tempting to choose the more straightforward option when comparing cash vs. accrual accounting, particularly if you’re a small business owner with few resources.

1. It is more precise than cash basis accounting, which only records transactions upon receiving money. Accrual basis accounting gives a more realistic picture of both income and expenses in the present. Financial institutions typically look at businesses more favorably if they employ accrual basis accounting when applying for a business loan.
2. It is Generally Accepted Accounting Principles (GAAP) compliant. While you might not be concerned about adhering to GAAP, remember that if your objective is to expand your firm, you’ll need a clearer picture of your finances, which only accrual accounting can provide. If outside investors are part of your plans, backing up your numbers is crucial.
3. It offers better financial preparedness. Since it incorporates unpaid bills and unreceived funds, accrual basis accounting gives you more precise revenue and cost reports. Planning and budgeting become more accurate as a result.
4. There are many tax advantages associated with accrual basis accounting, including the ability to write off expenses like wages, commissions, utilities, insurance, and interest payments that you accrued at year’s end but are yet to pay. Additionally, you can analyze your receivables and write off any accounts that are impossible to collect, lowering your taxable income.

Between cash and accrual accounting, the accrual approach better suits your company’s needs in the long run. Most accounting software makes monitoring your company’s financial health easy using both cash basis and accrual approaches. However, you must document your income and expenses consistently. So, why not choose accrual accounting to monitor finances in real-time?

We hope you’ve got some clarity on why you should opt for accrual accounting for your business. For more details on the impact of accrual accounting on business reporting and decision-making, check out our blog.