What is accrual accounting, and how is it different from cash accounting? More importantly, what does using the accrual basis mean for your business? Join us as we unpack the what, why, and how of accrual accounting to help you better understand your business’s financial health.
Accounting Methods: Cash vs. Accrual
There are two main accounting methods:
1. Cash Accounting: A simple method where transactions are recorded when cash is actually received or paid.
2. Accrual Accounting: Here, transactions are recorded when revenue is earned and expenses are incurred, regardless of cash flow timing.
The key difference between these methods lies in when transactions are recorded. Additionally, accrual accounting is the approach endorsed by major accounting bodies, so it’s typically required for formal financial reporting. Under accrual accounting, profit (recorded as revenue and expenses) does not always align with your cash flow, making it essential to track all three main financial statements—income statement, balance sheet, and cash flow statement—to get a full view of profitability and cash flow.
Why Accrual Accounting Matters
If cash accounting sounds simpler, why should you consider accrual accounting? While it may be more complex, accrual accounting gives a more accurate picture of financial position. With modern accounting software like Xero, understanding and implementing accrual accounting has become much more accessible.
Accrual accounting is also required under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), making it mandatory for many businesses, especially larger ones.
Cash vs. Accrual Accounting in Action
Let’s look at a scenario to highlight the differences:
Imagine Joel, a clothes manufacturer, needs to make 100 shirts for a retailer by the end of July.
• He invoices the retailer for $10,000 with a seven-day payment term.
• He spent $6,000 on materials in June.
This gives Joel a $4,000 profit. However, how this profit is recorded depends on the accounting method.
• Under Cash Accounting: Expenses would be recorded in June, when materials were bought, and revenue in August, when the client pays.
• Under Accrual Accounting: Both revenue and expenses are recognized in July when the revenue is earned and the expenses are incurred.
This example shows the “matching principle” of accrual accounting, where related revenue and expenses are recorded together, giving a consistent picture of monthly profitability. Without this, Joel would see a loss in June and a large profit in August, creating a misleading view of his business performance.
Let’s consider another example: if Joel is paid $10,000 in advance in May, before making the shoes (which cost $6,000). The revenue and expenses would still be recorded in July, under accrual accounting.
How Accrual Accounting Impacts the Balance Sheet
Accrual accounting also impacts the balance sheet. When revenue is recognized, an accounts receivable asset is created to reflect the right to receive payment. When Joel receives payment, the accounts receivable asset converts to cash. Under cash accounting, however, there would be no accounts receivable, as revenue is recorded only when cash is received.
Now, you might think, “This process eventually results in the same profit by August, so why bother with accrual accounting?” Good question! In a business with hundreds or thousands of transactions, timing discrepancies would make it very hard to get a clear view of profitability using cash accounting alone.
Pros and Cons of Accrual Accounting
Pros
Provides a clearer view of profitability
Offers a better understanding of financial position
Cons
Requires more accounting expertise
Can make cash flow tracking more complex
Accrual accounting may require some additional effort, but for businesses that want a more accurate picture of their finances, it’s well worth it.
Contact us to find out how we can help you with your accounting needs!
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