Every small business needs to keep track of its income and expenses. For the smallest businesses, recording income as the money that is received might be easiest. This is known as cash-basis accounting.
But as your business grows, you may need to track the revenue that is outstanding — that’s where accrual accounting comes in. But what is accrual accounting, exactly? Is one better for some types of businesses more than others? Read on to find out.
What is an accrual in accounting?
An accrual in accounting is a recording of a transaction (either expense or revenue) when the transaction takes place, rather than when money changes hands. For example, you might record revenue on project completion rather than on invoice payment, or you might record an expense when it’s incurred but not yet paid for.
Accrual-basis accounting generally provides a more realistic idea of the income and expenses of a business during a given period than cash-basis accounting. However, this comes at the expense of obscured cashflow — your records might show a lot of revenue, but if the invoices are outstanding, your actual bank account funds might be low.
Accrual basis accounting vs cash basis accounting
Accrual-basis accounting and cash-basis accounting are both valid options — like almost anything in business, each choice has its pros and cons. The primary difference can be seen when revenue and expenses are recorded in your ledger — immediately or when the transaction clears and money leaves or enters your account.
Choosing between cash accounting and accrual accounting often comes down to the size of your business, but there may be other factors that are relevant for you. Let’s explore.
Pros and cons of accrual accounting
While accrual accounting is popular among many businesses, it does have its positives and negatives. Let’s take a closer look at some of the main ones below:
Pros of accrual accounting
1. Immediate feedback
Invoice payments are rarely immediate, which can mean delays in when you record transactions and view changes to your business’s financial status. Accrual accounting prevents this issue.
2. Plan with confidence
You have a much more accurate picture of your business’s finances with accrual accounting, so you can more easily plan for future changes.
3. Improve financing options
Since accrual accounting provides a more comprehensive (and often more accurate) view of your business, it can help make it easier to get approved for long-term financing — something that’s important for many small businesses.
Cons of accrual accounting
1. More complicated
Accrual accounting tends to be more complex, simply because you have to watch your invoices, rather than just your bank account.
2. Potential inaccuracies in cashflow forecasts
Since the income recorded in your account is based on projects completed or items delivered, but not on actual payments, it can be tougher to forecast exactly when money will hit the account.
3. Pay tax on unrealised income
You may have to pay taxes on your recorded income before the customer actually pays the invoice. If they end up not paying, the process to reclaim the taxes paid can be time consuming.
Who uses accrual accounting?
Larger, more complex businesses tend to use accrual accounting.
Cash accounting definition: What is cash accounting?
Cash-basis accounting is essentially the opposite of accrual accounting — instead of expected payments, you record the actual payments, either to or from your business.
Pros and cons of cash-basis accounting
Similar to the accrual accounting method, cash-basis accounting has its own set of pros and cons. We’ll take a closer look at each of these below:
Pros of cash accounting
1. Simple single-entry system
Since you’re recording actual income and expenses, the math with cash accounting is much simpler. There’s no need to track accounts receivable or payable.
2. Potential tax advantages
When you’re recording only the income you’ve actually received, you’ll pay taxes on money you have (as opposed to money you’re expecting to have in the future). Additionally, you can control the timing of transactions for more favourable tax consequences.
Cons of cash accounting
1. Doesn’t show the full picture
Cash-basis accounting doesn’t show your business’s liabilities, so you don’t get a clear picture of how much money you truly have to spend.
2. Restricted use cases
If you offer credit, or need inventory to account for income, you may not be able to use cash accounting.
3. Ineffective for planning
Since cash accounting only shows a snapshot of your finances, it can be difficult to do any kind of long-term planning or analysis.
Who uses cash accounting?
Cash accounting is generally used by smaller, newer businesses or those with simpler needs and structures.
Categories in accrual accounting
Accrual accounting consists of a few different types of transactions. Since it tends to be more complex than cash basis accounting, it might be helpful to define what some of the key transaction categories are.
Accrued revenue
What it is: Revenue for services performed during one month but billed in another. A common example of this is utility services like electricity or water. The company provides the service, reads the meter, and sends the bill, which is paid the following month (“following” being the key word).
How it’s recorded: Accrued revenue is recorded by crediting the revenue account and debiting the accounts receivable. Accounts receivable is the remaining balance of money owed to a business for products or services.
Accrued expenses
What it is: An accrued expense is simply an expense your business has incurred but hasn’t been billed for yet. Salaries are one of the most common accrued expenses. Sick days and paid time off for employees are other examples.
How it’s recorded: Accrued expenses are recorded by debiting the expense account and crediting the accounts payable — essentially the reverse of recording accrued revenue.
Example of accrual versus cash accounting
To help illustrate the difference between accrual and cash basis accounting, let’s run through a quick example.
Imagine you run a small business that sells landscaping services to other local businesses. Many of those businesses have Net30 or Net60 payment terms. This means the buyer is expected to pay within 30 or 60 days of the goods being dispatched, or the services rendered. These terms can result in actual cash payments being delayed for a month or two after invoicing.
For the current month, you perform $40,000 worth of work for these local businesses. This is your most successful month yet! And if you use accrual basis accounting, your records show the full $40,000 as revenue.
Now let’s say you use cash-basis accounting. Only a handful of the businesses you performed work for actually paid their invoices the same month, totalling $8,000. When you go to review your books, you don’t see that it was your best month yet — all you see is that $8,000.
This is one of the reasons that accrual accounting is so much more common — by using cash-basis accounting, you’re missing the big picture of your business and may not know when to make big decisions, such as purchasing new equipment or hiring a new employee. With accrual accounting, you get the full picture of the health of the business.
The effect of accrual accounting on taxes
Your choice between accrual and cash accounting has important tax implications. That’s because with cash accounting, you record income when you receive it, which may be a month or more after you actually earn it. If those months fall on the line between tax years, it can have a drastic impact on your liability. The same is true for expenses you might deduct.
As an example, let’s say in the month of March 2021 you invoiced clients for a total of $10,000 but only received payments for $2,000.
With cash accounting, you would report $2,000 on your 2021 taxes, and the rest would go on your 2022 taxes when you file them. With accrual accounting, the full $10,000 would go on your 2021 taxes.
Is accrual accounting right for your business?
Is your business growing? Are your accounting needs becoming more complex, with an increasing number of variables and outstanding balances to juggle? If so, it might be time to consider accrual accounting.
Accrual accounting is based on the idea of tracking income and expenses when they are earned or incurred, rather than when money changes hands. As such, they can give you a much better long-term view of your business’s activity and health.
If you’re worried about complexity, remember that accounting software can take care of a lot of the more manual, tedious, and error-prone work for you. MYOB has a small business accounting solution perfect for growing companies. Start a free trial today!
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