Accrual accounting is the preferred method of accounting for all business operations. Any publicly traded company must comply with the principles of accrual accounting. Small business operations can choose between cash and accrual accounting for their records. Although cash accounting is the easiest to work with as a small business operation, accrual accounting will provide a more accurate picture of the financial status and affairs of any business operation.
In general, accrual accounting records financial obligations as they arise. When an individual purchases an item using his credit card, the purchase is recorded in the records of his account. Upon presentation of the credit card statement, the account holder is obligated to pay the bill. Accrual accounting is just like the credit card, once the purchase is made, the obligation is recorded. In cash accounting the purchase is not recorded until the payment is actually made.
One of the concepts of accounting is matching of expenses to the revenue generated by that cost. Accrual accounting accomplishes the matching of revenue and expenses associated with that revenue. The nonpayment or cash issue is revealed in the balance sheet as an obligation to pay via accounts payable or credit card payable. It is important for any small business owner to understand his obligations and how much is truly spent to earn the respective revenue.
To better understand accrual accounting as an owner of a small business, you should understand when it is required to implement accrual accounting. Also, how accrual accounting benefits the small business owner with understanding the balance sheet and the profit and loss statement (income statement). Finally, how to use the information to understand cash flow. The sections below describe and illustrate these respective issues.
Is Accrual Accounting Required?
Simple answer: NO, it is not required. However, the Internal Revenue Service does have guidance and requirements that have to be met when filing tax returns. In general, they do require some form of accrual accounting (modified, special, Section 263, etc) in certain circumstances or at some level of revenue. In general, the IRS mandates accrual accounting when an entity has more than $5,000,000 in sales. See your CPA for guidance on whether or not you must use accrual accounting for tax purposes.
There are no Accrual Cops with badges that will come and site or arrest you for failing to prepare your books on the accrual basis of accounting. Honestly, the guy next to you doesn’t really care. It’s your business, run it your way!
Now given what I just said, this doesn’t mean that you should just go with cash basis of accounting. If you are a truly small business such as a weekend vendor or a food vendor selling lunch items, then yes, cash accounting is definitely in your best interest. Stop reading here and just use cash accounting. I strongly endorse the KISS program (Keep It Simple Stupid). Cash accounting is the best example of the KISS program.
Accrual Accounting is absolutely the best method of accounting to use in pretty much any business operation. Its advantages far outweigh the financial savings of using the cash method. If your business operation has sales greater than $100,000 per year, I encourage you to use the accrual method of accounting. If your sales are greater than $2,000,000 per year, then the financial costs of using accrual accounting will be easily recouped by proper utilization of accrual accounting. The next two sections cover the value for the balance sheet and the profit and loss statement.
Accrual Accounting’s Impact on the Balance Sheet
The balance sheet is the best tool for a small business owner to understand the total picture of his operation. The profit and loss statement illustrates how business is performing over an extended period of time (one accounting cycle and typically the calendar year to date are in side by side columns). The balance sheet is a snapshot or an instant moment in time. Usually it is prepared for the end of the accounting cycle, last day of the month. The very next day, another transaction will affect the balance sheet, a sale is recorded and inventory is reduced, cash is deposited and so on. The change in inventory and cash is reflected in the bottom equity section which gets an ‘Earnings to Date’ update from the income statement (profit and loss). See How to Read the Balance Sheet – Simple Format and How to Read a Balance Sheet – Equity Section Simple Format for more help in understanding the basics of the balance sheet.
Under the cash method of accounting, bills are paid as cash is available. In essence the bills are a pile of papers in the accountant’s office. There is no accounts payable on the balance sheet to inform the owner of future cash outflow. He simply has a cash account balance, fixed assets, and on the other side of the balance sheet, some long term liabilities and equity.
With accrual accounting, the balance sheet expands to provide information on receivables, payables, inventory, payroll obligations (benefits, costs of vacation time, payroll taxes), short term notes and other types of assets/liabilities. This is crucial information to fully understand the financial position of the business operation. As an example, you would want to know how much money is owed to you for sales on credit. This allows you to calculate how much cash will come into the bank account over a certain period of time. You would want to know who owes you money, how much they owe you, and identify issues with certain customers, slow payers and high balances. This one element of business alone is justification for accrual accounting. As a small business owner extending credit, you are going to keep some form of a receivables log anyway, why not just include this in the regular accounting records.
As for amounts that have to be paid out, you will want to know to whom, how much, when is it due in order to ensure adequate cash to pay those bills. Again, this is justification to implement accrual accounting. As businesses grow, they extend credit and use credit to speed up activity and increase the overall value of the operation. Accrual accounting places this information on the balance sheet so the owner can fully grasp his financial position and make better decisions.
Accrual Accounting’s Value with the Profit and Loss Statement
One of the primary tenets of accounting is the matching principle. Simply stated ‘Expenses are matched against the revenues earned’. Accrual accounting accomplishes this tenet of accounting. As the sale is made, the corresponding costs of that sale, inventory, labor and other expenses (insurance, shipping, warranties) are included in the profit and loss statement so the reader can clearly understand how much it costs to make the respective sale.
In accrual accounting, as inventory or labor is consumed or utilized, it is accumulated on the balance sheet as inventory or ‘Work in Progress/Process’. When an item is sold, the dollar value of that item is transferred from the balance sheet to the profit and loss statement. Any labor associated with that item is also transferred to the P&L. When the sale is recorded, the customer pays by cash or via credit. If credit; the dollar value is recorded on the balance sheet as an accounts receivable. Notice how the inventory and labor value along with the associated profit becomes a balance sheet item when credit is extended. The associated profit is included in the equity section of the balance sheet in the ‘Earnings to Date’ line.
Accrual accounting provides a clearer picture and matching of expenses to the revenues earned. In the cash method, those inventory and labor items were already paid and most likely included in an earlier accounting cycle. Furthermore, the revenue is only recorded when the cash is received thereby distorting the profit and loss statement. This isn’t a critical issue for a really small operation, e.g. less than $100,000 a year in sales, but it is substantial in operations with sales of more than $100,000 per month. An owner of a business needs to understand how much it truly costs to make those sales. In a really small operation, the owner can feel the value, as the operation grows; he needs real quantifiable information to make good decisions.
Accrual Accounting and Cash Flow
Accrual accounting relies more on the balance sheet to identify issues that arise with cash flow. If obligations exceed cash available to pay those obligations, the owner needs to understand why the company didn’t produce enough cash during the accounting cycle to pay the bills when they come due.
In addition, the balance sheet sections help the owner understand the totality of his cash situation. As payables rise in dollar value and there is no corresponding increase in receivables or cash, then something is wrong. He needs to see the whole picture to truly evaluate his situation. As the company grows and prospers, more employees are hired; there is greater inventory and more bills that have to get paid. The small business owner has to make decisions about cash, see Cash is King for more information about the value of cash.
All of this is known as cash flow. As an owner, you need to understand the resources and use of cash in your business operation. Accrual accounting provides the necessary information to make the best decisions possible.
The above identifies the value of accrual accounting. No, it is not required, but your better business operations use this method to further success. The cost to implement and maintain is minimal in comparison to the value this method provides to the small business owner. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.