Accrual accounting

A business can do its books on cash basis and on accrual basis. Cash accounting is relatively easy to grasp: transactions are recorded when cash actually changes hands. No dramas there. But what does the other method, the accrual accounting, entail, and when should a business choose it for its recordkeeping?

Imagine you’re running a small marketing consulting business, and you complete a project in November. You’d record that income in November, even if your client paid you a deposit in September. Similarly, if you receive a bill from your supplier in November but don’t pay it until December, you'd still record the expense in November. This way, your income and expenses are matched to the periods in which they were generated.

What is Accrual Accounting?

Accrual accounting records the financial transactions when they occur, regardless of whether the money has been paid or not. So, revenues are recognised when they are earned, and expenses are recorded when they are incurred.

Therefore, it reflects a more accurate and realistic view of a business’s financial performance, especially for businesses providing payment terms to their clients and receiving credit from their suppliers.

So, if our imaginative consulting business delivers an advisory job today and expects to be paid in two months, they would record the revenue today in accrual accounting, even though they will receive the money later. Furthermore, suppose the work was partly executed by an external subcontractor with whom the business agreed to pay only when the client paid for the service. In that case, the contractor's expense will be recorded now despite no payment has been made.

Advantages of Accrual Accounting

1) Tracks receivables and payables

Unlike cash accounting, accrual accounting tracks receivables - what the customers owe to the business - and payables - what the business owes to the suppliers. This helps understand not just the cash the company actually have but also the expected money coming in and the future payment obligations the business needs to fulfil.

2) Matching income with expenses

Accrual accounting links the revenue with the expenses that helped generate it – this is the so-called matching principle 😉.

By doing so, the business gets a clearer view of its profitability and performance, reflecting both current and future financial obligations. With cash accounting, it could happen that the business’ financials show profits in a month, but that could just be because no bills have been paid yet.

3) More accurate financial planning

With accrual accounting, it’s evident what’s coming down the road financially - whether it’s upcoming payables or expected income from clients. This helps avoid any cash flow hiccups and surprises when big expenses hit, such as supplier payments or tax obligations, and enables more accurate financial planning and smarter financial decisions. This is the reason why banks prefer financial statements prepared on accrual basis when the business wishes to borrow money.

4) Compliance with financial reporting standards

In many countries, businesses that reach a certain size or revenue threshold are required to use accrual accounting for tax and financial reporting. As mentioned before, it’s more accurate and gives stakeholders a clearer idea of how the business is performing.

So, if the company is on a growth path, it’s helpful to switch to accrual accounting sooner rather than later to get used to its nuances. 

Disadvantages of Accrual Accounting

1) Complexity

Accrual accounting can be more challenging compared to the rather straightforward cash accounting. It requires a bit more effort and a higher level of professional expertise. Cash accounting can be done “on paper” or in a spreadsheet, but that’s not true for accrual accounting. Accounting software is needed for accurate record-keeping.

But let me highlight something: subscribing to accounting software doesn’t automatically mean that the accrual accounting is done and dusted. Using a software definitely helps record invoices and bills correctly and separate the “time when it happened” from the “time when it’s paid”. There are a multitude of accounting rules, principles and procedures defined by the accounting standards and regulations that need to be followed when preparing the financial statements for an entity.

This complexity can be highly overwhelming for small businesses or new entrepreneurs.

2) No immediate cash-flow insight

One significant downside of accrual accounting is that it doesn't provide a clear snapshot of the cash currently in the bank account. Since income and expenses are recorded as they occur, the income statement doesn’t reflect the available money. So, the profit on paper can be significantly different to their cash position – this is the characteristic of accrual accounting that business owners mostly struggle to understand: why there’s no profit when there’s plenty of cash in the bank or vice versa.

As a result, when doing accrual accounting, the business needs to keep a close eye on the cash flow to ensure they can meet upcoming obligations.

3) Time and resources

Managing an accrual-based system can require much more time and resources compared to cash accounting. The businesses must use accounting software; they may need to invest in more add-ons such as inventory management systems, invoicing platforms, reporting software, etc.

In most cases, companies using accrual accounting may need to hire a bookkeeper and/or an accountant to ensure everything is recorded accurately and on time.

Who should use Accrual Accounting?

First and foremost, always check your country’s rules and regulations around accrual accounting. 

Accrual accounting is typically the recommended method for

• companies that offer products or services on credit and don’t pay their vendors on the spot, hence the majority of their financial transactions are not instant cash transactions
• companies with significant inventory
• growing businesses with more complex operations
• businesses managing multiple projects at once with staggered revenue and expense timing
• companies required by law to report on an accrual basis due to size or revenue thresholds

Use case for Accrual Accounting

Let’s look at a practical example!

Carla runs a  interior design firm. She takes on multiple projects at a time, invoicing her clients as soon as the project begins. Carla also buys furniture and décor on credit for her clients’ homes, often paying suppliers 30 to 60 days after the project is complete.

Using accrual accounting, Carla records the revenue as soon as she sends out her invoices, even if clients take months to pay. She also records her expenses when she orders materials, not when she pays the supplier. This gives Carla a clear and accurate snapshot of her business's financial performance; however, she needs to attentively manage her cash flow so she can pay the suppliers, her assistants and the tax obligations when they fall due.

Key takeaways

Accrual accounting offers a more accurate view of the business's financial health by tracking income and expenses when they occur rather than when cash changes hands. That said, it can be a little more complicated to manage, especially compared to cash accounting.

Cash accounting might be sufficient for businesses with cash transactions, like a small coffee van or a freelance photographer. However, as a company grows or becomes more complex and needs a clearer understanding of financial performance, the benefits of accrual accounting far outweigh its challenges.

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PS: If you want to get to know more about cash accounting, please read this blog article 👉 HERE.