Accrual basis accounting tracks incoming and outgoing cash flow based on when they are incurred, not when payment is made on them (which is done in cash basis accounting). By tracking when the invoice is created rather than just when there is a cash transaction, you have more accurate data of your current assets for analysis before the end of the fiscal year. Also, using this kind of tracking for journal entries means that you have a much more accurate reflection of your company's financial health.
The accrual accounting entry method is endorsed by both GAAP (generally accepted accounting principles) and the IFRS (international financial reporting standards). In fact, the accrual accounting method of recording income and operating expenses is standard per the IRS. However, small business owners with gross receipts under $25M are allowed to choose whichever method they prefer.
How accrual accounting works
The main downside of accrual accounting is that the method for recording transactions can be intimidating and confusing for newcomers compared to the cash method. While more taxing, learning about this precise method will help you better track your cash inflows and outflows!
When you send an invoice to a client, it can take time for them to pay it. Accrued revenues are an asset account that helps record income before it has been received. Usually, you will see these are things such as invoices awaiting payment or repeat income that you track before receiving (such as rent or subscription fees). These are shown on your balance sheet as receivables.
Often expenses don't sit too long on your balance sheet before being paid. However, there are cases when they are able to be tracked for your financial statements. Often within the liability account category, expenses tracked this way include future interest expenses, upcoming tax liabilities, goodwill, future utility company payments, and payroll estimates. These expenses show as expenses on your income statement and also are an accounts payable within current liabilities.
Prepaid expenses vs. accrued expenses
Prepaid expenses are payments you make before receiving goods or services from your supplier. Accrued expenses are the opposite, payments you have yet to make on goods and services. Prepaid expenses, due to this, count as assets, while accrued are liabilities.
An example of accrual accounting
When you incur an accrued expense, they show as their own line item within your balance sheet. Accrued expenses are a current liability and often are estimates since you may not have an exact invoice at this time. The most commonly seen examples of accrued expense are employee wages and salary accruals, which are often tracked before being paid every month.
An example of an accrual revenue account is any payments that are received every month at the same time. Rent is a great example, while another example is utility companies that get paid by the meter.
Accrual accounting vs. cash accounting
As previously mentioned, accrual accounting considers all upcoming invoices or expenses at the time they are incurred. Cash accounting only starts tracking those items once there has been a payment. Accrual accounting is a much more accurate snapshot of your company's financial positions at any given time since they are consistently tracking your transactions, but that doesn't mean that cash accounting doesn't have its place.
Cash accounting is more popular than accrual accounting in some businesses and sectors. Looking only at net income is significantly easier for smaller companies and can make more sense when there isn't a lot of ingoing or outgoing inventory to be concerned about. Unfortunately, if you do start to accrue expenses, the surprise costs can be treacherous for small companies that have loose approvals processes and don't keep track of these items as closely.
The impact of accrual accounting on your business
Switching to accrual accounting can have huge benefits for your company, from analyzing your current financial positions more accurately to having more confidence in your buying power.
While your accrued expenses or revenues don't directly affect your cash flow as they are transactions that have not yet happened, they give you insight into what will happen upcoming to your cash flow. That means that you can make more educated financial choices, including understanding your actual spending power. A more firm understanding of the money flows throughout your company means you have more buying flexibility and increased security as you make decisions.
Because you track all incoming invoices before they are actually paid, you still have to pay taxes on that projected income even if the payment isn't received before the end of the fiscal year. While this can be frustrating, you can use this to your advantage by deferring these items towards the end of the year.
Is accrual accounting right for your business?
For large companies, accrual accounting is the standard. For smaller companies, you can make the decision between accrual accounting and cash accounting. Small businesses, especially those without a lot of inventory or cash flow, may not benefit from accrual accounting, and it may add unneeded complexity to their accounting processes. With that being said, there are certainly some advantages even for those smaller companies that use this process.
Pros of the accrual method
- Using the accrual method gives you an accurate, reliable snapshot of your business's overall cash flow. Knowing where your finances stand empowers you to make more flexible decisions and more accurate analyses.
- Tracking your expenses and revenue as they incur shows you a clearer picture of your income and expenses to help you make intelligent financial decisions.
- When you implement accrual accounting, you are able to predict your long-term economic trends better.
- Depending on how you report, you have the option to defer income on your tax return for a potentially more significant tax break.
Cons of the accrual method
- The accrual method is more complex than other accounting methods, meaning it may not make much sense, especially for small businesses with low or no inventory.
- Because you are tracking transactions before they are paid, the accrual method doesn't necessarily show a clear image of how much cash you have on hand at any given time.
- Since there is so much extra tracking, crediting, and debiting, the accrual method can be time-consuming and overwhelming for beginners or smaller accounting teams.
Automate accounting with Routable
Are you considering accrual accounting for your company? Implementing an automated payment solution such as Routable can help make the change less daunting! We have features including API integrations for bulk processing, automatic invoice routing, revenue collection, and consistent tracking and audit compliance, making accurate accounting easy for your team regardless of size. Start eliminating all of your team's time on manual data entry that can lead to mistakes and overworked staff, and empower your employees with automation! We can make your payments process faster, safer, and more scalable. Whether a small company looking to implement accrual accounting, or a large one looking to do it more efficiently, Routable can help you make your payments efficient, quick, and painless.
By implementing Routable and its automation features, customers have seen 40% saved on bill payment and mass payout costs, as well as a 70% reduction in manual, repetitive tasks for their teams. As you consider looking into accrual accounting, Routable can help make the transition smooth by integrating directly into your current workflow and software, helping make a move seamless and easy.
To learn more about how Routable can help you with your ACH withdrawals and payments, contact us for a demo.