The whats, whys, and hows of accrual accounting
8 minute read
What is accrual accounting, and how does it differ from cash accounting? More importantly, what exactly does accounting on an accrual basis mean for businesses?
Follow us as we dive into the what’s, why’s, and how’s of accrual accounting – so you can better understand the financial position of your business.
Continue reading below!
Methods of accounting
In general, there are two methods of accounting.
- Cash Accounting. A relatively simple method where transactions are recorded at the time that cash is received or paid.
- Accrual accounting. This occurs when transactions are recorded at the time that revenue is earned and expenses are incurred.
As you could probably tell, the main difference between these two methods is in the timing in which the transactions are recorded.
The other key difference is that accrual accounting is the method of accounting endorsed by key accounting bodies. Thus, it is often mandatory to base your financial statements through this method.
You might remember from observing the statement of cash flows that your profit may not always equal your cash – and accrual accounting is the main reason for this.
Under accrual accounting, the recording of your revenue and expenses (i.e. profit) happen independently from when cash is paid or received.
This is why it’s important to keep an eye on all three of your key financial statements under accrual accounting so that you have full visibility over your profitability and cash flow.
Why accrual accounting is important
You might be thinking that since cash accounting sounds simpler, why should you bother with understanding accrual accounting?
Believe it or not, accrual accounting makes your financial statements easier to understand, and gives a more accurate picture of your financial position.
While it does involve some accounting expertise, accounting software such as Xero have easily solved this by making it more comprehensible, convenient, and accessible.
More importantly, the accrual basis of accounting is advocated under both generally accepted accounting principles and international financial reporting standards.
This makes it mandatory for most businesses, especially if you’re a large one.
Differences between cash and accrual accounting
Let’s delve deeper and look into the differences between cash and accrual accounting.
Here’s the scenario: Bruce is a shoemaker who is required to make 50 pairs of shoes for a retailer by the end of July.
- Bruce will hand the retailer an invoice for $5000, stating that they have 7 days to make payment.
- Bruce had bought all his resources in June, for a total cost of $3000.
With that, Bruce has made a $2000 profit on the shoes for this transaction.
However, how we record that profit in our financial statements under accrual accounting differs from that of cash accounting.
As you can see,
- Under cash accounting. Expenses for the shoes would have been recorded back in June when the materials were bought. Revenue would thus be recorded in August when the client pays their invoice 7 days after it was issued.
- Under accrual accounting. Revenue will be recognized in July because that’s when the revenue was earned. The cost to make the shoes is only incurred when those shoes have earned revenue for the business, so the cost will be recorded in July too.
This also illustrates the “matching principle” of accrual accounting, where revenue and expenses related to each other are “matched” in the profit and loss.
If Bruce were to review June’s performance under cash accounting, he would be shocked to see a loss of $3000. However, in August, he would see a profit of $5000 and think that business is going great again.
With cash accounting, Bruce would be going on a rollercoaster of emotions each month.
Meanwhile, accrual accounting shows the entire profit in the month where the revenue was earned and the expenses incurred – and this is a far more consistent way to record your profitability.
With accrual accounting, Bruce would have a clear picture of his profitability.
Let’s run through another quick example, this time assuming that Bruce is paid the $5,000 by the retailer in advance, in May, before he makes the shoes for a cost of $3,000. But he still delivers them in July, as in the previous example.
How accrual accounting impacts the balance sheet
When revenue is recognized under accrual accounting, an account receivable asset is also created in the balance sheet for $5000. This is to reflect that Bruce now owns the right to receive that cash from the retailer for his services. Bruce’s accountant will convert the accounts receivable asset to cash when payment from the retailer is received.
Under cash accounting, there’s no need for an accounts receivable balance as revenue is recognized at the same time that cash is paid. This shows how the balance sheet is impacted by accrual accounting.
With that, you might be thinking, “these scenarios all end up with the same level of profit by August, so I’m still not convinced in going to all that effort”.
Great thought! However, think about a business with hundreds or thousands of these types of transactions. There would be timing discrepancies all over the place which would make it almost impossible to have a clear picture of profitability at any one time.
Pros and cons to accrual accounting
Here’s a summary of the pros and cons of accrual accounting:
|✅ Clearer understanding of profitability||❎ More complicated and requires expertise|
|✅ More aware of your financial position||❎ Difficult to track cash flow|
And there we go! Hopefully, you now understand why accrual accounting makes understanding business performance much easier. It truly is an essential part of starting and growing your business.
Looking for more tips for your business? Here are 10 tips for excellent financial business management.
If ever in doubt, don’t hesitate to reach out to the trusted professionals at Sleek to help out with your business finances! Our friendly team is here to help you manage your business accounting and bookkeeping.