Businesses often use accrual accounting or cash accounting to record their financial transactions, but the former is highly regarded as a more accurate method.
Perhaps you’re thinking of switching from cash accounting to accrual accounting, or you’re a self-employed accountant who wants to provide their clients with the best service you have to offer. Either way, we’ve got you covered.
You are an entrepreneur who is enthusiastic about expanding your small firm. Perhaps you’ve found your ideal niche market by developing websites for local restaurants or installing high-end home security systems. You’re enthusiastic about your company’s services, expanding your business, and refining your brand.
Your emphasis on those aspects of your business is critical to its success, but you may be forgetting an equally crucial accounting decision: Do you utilize cash basis accounting or accrual accounting? After working with small businesses for many years, I am confident that accrual accounting is the greatest option for your firm, especially as it grows and seeks new prospects.
This blog post will introduce accrual accounting, discuss its benefits, and provide some examples to illustrate how accrual accounting can be used to create long-term success!
Accounting For Long-term Success
What is Accrual Accounting?
Before we can get into how to utilize accrual accounting for long-term success, we first need to be familiar with what it is exactly. Accrual accounting is a method of recording revenues and expenses that are earned or incurred over time.
It provides more accurate information about an organization’s financial situation than cash-based accrual accounting does, as it captures all transactions in the period they were earned or incurred even if payment for them has not yet been received.
This can be very useful to understand where a company’s money is coming from and being used at all times. It allows business owners to make informed decisions with their finances.
The Benefits of Using Accrual Accounting
Accrual accounting has a significant impact on the kind of information you’re getting out of keeping your books. It can help you make more informed decisions about your financial situation and provide a clear view of how well (or poorly) your business is performing.
It also helps show when expenses were spent instead of just providing information on which ones have already been taken care of. This gives businesses insight into their finances over time.
Many accounting software programs use accrual accounting already. By using this accounting method from the beginning, you can avoid having to face a learning curve in the future.
The Drawbacks of Using Accrual Accounting
While accrual accounting does provide businesses with many benefits, it also has some downsides that need to be considered.
Accrual-based systems are more complex than cash-basis ones and come at the cost of additional time to implement them. Since accrual calculations depend on estimates for expenses from tax laws and other factors, there’s always a risk that the estimates are incorrect.
Accrual Accounting vs. Cash Basis Accounting
Small businesses, which frequently must learn fundamental accounting informally and quickly, can utilize any approach of accounting, although the methodologies differ.
A transaction is not recorded as a sale until your customer pays you, and an expense is not recorded as an expense until you pay for it. You must exchange money in order to account for it.
Sales are recorded as accounts receivable in accrual accounting at the time you sell anything, such as when you deliver an invoice to a customer. When you get an invoice from a vendor, you record the expense as accounts payable.
Consider the following scenario: you are the owner of a brand-new plumbing company. In April, you made ten service calls and sent your customers $5,000 in bills. At the end of the month, five clients had paid a total of $2,500 in invoices. During the same month, you paid an invoice for $800 worth of tools.
If you use cash basis accounting, you made a profit of $1,700 — the difference between what your customers paid you and what you paid for the tools.
If you use accrual accounting, you made a profit of $4,200 — the amount of the invoices you submitted less the cost of the tools.
Depending on the form of accounting you use, your company’s financial accounts will look substantially different at the end of April, even though the identical events occurred in both cases.
How to Implement an Accrual Accounting System in Your Business
Accrual accounting systems are a bit more complex than other methods. Fortunately, there are some steps you can take to make the accrual-based system work for your business:
- Track all revenues and expenses that occur over time. To do this, you can make use of online receipt or invoice generators to save time.
- Create an accruals journal or excel spreadsheet where you record these transactions as they happen. Also, keep track of when certain costs will be incurred so that you know how much they’ll cost by the end of each year.
- Assign specific accounts to different types of income/expenses based on their nature (e.g., “products,” “services,” etc.). This will help give you a better idea of your business performance.
Know that it might take some getting used to before you can start seeing the benefits accruals have to offer. Once implemented properly, it will prove to be one of the best ways to keep track of your company’s financial situation. It will also provide you with useful information about your company’s well-being at any given moment.
Why Should Your Small Business Use Accrual Accounting?
There are several compelling reasons why I believe small businesses should utilize accrual accounting, even if it appears to be more complicated. For starters, it makes it easier to track revenue and expenses. Second, it enables you to create more detailed financial statements for those outside your organization. Third, it enables you to debt. Fourth, assess how sophisticated your business activities are at this early stage.
Perhaps demand for your pet-sitting service has skyrocketed as news spreads about how dependable you are and how well you care for their dogs. You may have employed a few people. You quickly discover that you’re having difficulty keeping track of who owes whom.
With accrual accounting, you simply record Ms. Jackson’s debt as an accounts receivable transaction. When you consider that amount contrasted against the recent price for your website revamp with the prominent photo of the Labradoodle at the top, it gives you some peace of mind. You quickly understand where your money is going and where it is coming from. Determine crucial ratios that you may require as your firm expands.
Second, when your company expands, others will be looking at your financial statements.
Accrual accounting provides those individuals with a better understanding of your company’s shape. If your graphic design business appears to be cash-strapped one month because you had to pay for a new computer, a quick look at your accounts receivable shows that your cash flow for the following month looks fantastic because your clients will be paying you many times the cost of that new equipment.
Keep this in mind as you consider your future credit demands. Perhaps you require a short-term line of credit due to an increase in your accounts receivable. If you provide your banker a cash accounting balance sheet, he won’t even notice that you have accounts receivable because it won’t be on the balance sheet. Using accrual accounting, your lender has a more accurate picture of your company’s health rather than a false one based on a snapshot in time.
How to Avoid Common Pitfalls with Accrual Accounting
Of course, accruals aren’t without their pitfalls. To avoid making mistakes due to accruals, you should make sure that all your accruals are recorded. Rather than waiting until income is received, expenses and income are recorded as they occur.
Have a clear understanding of how much an accrual is supposed to be worth at any given moment, so you know whether or not what has been recorded matches up with reality.
Also, remember that there could be some errors depending on which method was used for accruing certain costs. For instance, if inventory cost flow assumptions were different from those assumed by management, the accruals would also be different.
It is important to keep this in mind and to stay on top of any changes in your cost flow assumptions to ensure your accrual amounts remain accurate.
Whether it’s about understanding the cash flow of your business as an employer or making paystubs as an accountant, accrual accounting is undoubtedly a powerful method that can bring long-term success to your company.
It has the ability to provide meaningful insights and accurate business trend predictions. It may seem like a daunting task due to its complexity, but learning about how to make the most of its benefits and avoid its disadvantages should prove to be useful in getting you started!