What is Accrual Basis Accounting?
In the strictest sense of the term, accrual basis accounting is when revenues and expenses are recorded at the times of their occurrence. This is in contrast to cash basis accounting, which records revenues and expenses when cash exchanges hands. For example, if a business sold $2,000 of its products but did not receive the cash until the following month, accrual basis accounting would record the $2,000 revenue in the same month as the sale whereas cash basic accounting would record the $2,000 revenue in the following month when the business received its cash.
What Are the Costs and Benefits of Accrual Basis Accounting?
Accrual basis accounting is much more complicated and time-consuming than cash basis accounting, which can make it inconvenient for small business owners who have to keep their books up-to-date while juggling the rest of their responsibilities at the same time. For example, there are a number of rules on when revenues and expenses can be recorded without cash exchanging hands, which can create serious errors on the financial statements when the bookkeeper either makes a mistake or misinterprets the situation.
However, accrual basis accounting also produces financial statements with much more faithful representations of the small business's financial realities. For example, a small business that sells most of its products on credit but continues to use cash basis accounting will have revenues and expenses on their income statements that do not match their actual activities during the same period of time.
Why Should You Use Accrual Basis Accounting?
This is important not just because it empowers small business owners to make better business decisions with fairer and more accurate information, but also because it increases the confidence of outsiders in the small business's assessment of its own finances.
After all, small businesses that use cash basis accounting can step up their collection efforts to boost their cash inflow in the short term, thus manipulating their net income in that particular period of time. In contrast, small businesses that use accrual basis accounting have no such recourse, which makes them more believable when their financial statements show positive outcomes.
On a related note, it is also important to note that accrual basis accounting is seen as being more professional than its cash-based counterpart, which makes its adoption a crucial step for small businesses that want to take the next step towards becoming bigger and better-established.
In the end, small business owners have to choose between accrual and cash basis accounting based on their own circumstances. Those who are still reliant on cash-based transactions can use cash basis accounting without creating too much distortion in their financial statements, but those who are beginning to use credit should consider making the switch sooner rather than later.
Disclaimer: LVRG, LLC. and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.