Entrepreneurs usually don’t go into business to spend all their time doing accounting. So, if you’re like most business owners, you may not necessarily be familiar with the options in accounting methodologies.
Accrual accounting is one of the two common methods used. The other is cash accounting. Here’s a look at the pros and cons of the accrual accounting method, to help you understand the advantages it offers over the cash accounting method for many companies.
What Is Accrual Accounting?
Accrual basis accounting is a method in which income and expense payment transactions are recorded when they are expected to occur in the future, based on agreements – not at the time when cash is actually received or spent. For example:
If Company A performs work under contract for customer Company B and uses the accrual accounting method, Company A will record the amount charged to the customer at the time the work is completed. The amount is entered into Company A’s income record even though the payment is expected to be received at a later date.
If Company B also uses accrual accounting, when the work is completed, they will record the amount in their payments record, although they may not pay the bill until some weeks or months later.
What Kinds of Businesses Use Accrual Accounting?
The accrual accounting method is required for public companies and some large organizations under the Generally Accepted Accounting Principles (GAAP). That’s the standard applied by the U.S. Securities and Exchange Commission. So, if your business is a small startup, or a medium-sized and growing business, you can choose the accounting method that you find works best for your needs. But, when your company becomes very large, whether it is still privately owned or traded publicly, you may be required to use the accrual accounting method in adherence to GAAP.
Pros and Cons of Accrual Accounting
Accrual accounting has its advantages and disadvantages. If you’re considering using this method, you need to be aware of both. That will better enable you to maximize the benefits of this accounting method and protect your company from potential issues.
- Accrual accounting streamlines strategic planning.
Because the accrual method represents future cash flow, it allows strategic planning that includes that future income activity. Planners can readily see points at which higher and lower cash flow can be predicted. That enables more accurate cash flow forecasting and strategic planning, which helps company leaders with positioning to maximize opportunities during periods of high cash flow and avoid periods of financial crisis due to unforeseen cash shortfalls.
- Accrual is much more transparent than cash accounting.
Cash accounting shows financial transactions when they actually occur, not when they’re expected to happen. Accrual accounting offers more transparency to the company’s financial position by representing the accounts with all the cash that will be received and paid out. That practice enables a company’s top management to understand and plan for upcoming periods based on a much more accurate picture of the business’s finances.
- The accrual method is GAAP compliant.
Your business may or may not be required to use the accrual method to satisfy GAAP. But, either way, there may be numerous good reasons to push ahead to implement it for your business. You should especially consider making the switch if your company is anticipated to reach a size at which accrual accounting will be required for GAAP compliance by the SEC. Putting the system in place as early as possible and becoming comfortable with it can be an enormous benefit when using it becomes a requirement.
- Switching to accrual accounting can be hard.
Switching over to the accrual basis accounting method can be fraught with challenges in both the development of a system and the implementation of processes. In many cases, a tiered system of implementation is necessary to make the complete change over a period of several years. Businesses with cash flow problems are likely to find the difficulties compounded.
- Using the accrual method can be difficult.
By contrast, cash accounting is pretty simple. You record your income and expenses as income is received and expenses are paid. Accrual accounting is more complex. It involves rules that must be diligently followed and processes that must be consistently performed accurately to record some types of income and expenses at the appropriate times. Further, tax forms, tax rules, and procedures are more complicated to follow in practice when using the accrual accounting method. A professional accountant is usually needed.
- The accrual method can expose you to fraud risks.
If you are doing all your business's accounting alone or with the help of a few office workers, the accrual method can increase your risk of internal fraud. To protect your company and help ensure consistent accuracy in your financial statements, you need a system of controls. You also need to educate yourself on the ins and outs of the accrual accounting method and understand the risks as fully as possible. (Small businesses have proven to be the most vulnerable to fraud in the United States.)
PRO TIP: To help protect your business from the risk of internal fraud, separate the powers and maintain dual control in your accounting when using the accrual method.
Accounting Options for Growing Businesses
Accrual accounting provides exceptional insights into a company’s financial position. However, transitioning to or managing an accrual accounting system can be quite difficult without professional intervention.
Outsourcing accounting services typically offer the most reliable and affordable option for growing businesses that are not yet ready for full-scope in-house accounting operations. An accounting service has the technologies and tools to automate processes and implement controls that can protect your business finances from fraud risks.
Making the Most of Accrual Accounting
Accrual accounting can be a powerful method of managing your business’s financial record. But, like cash accounting, it comes with both advantages and disadvantages. To maximize the benefits of using the accrual basis accounting method:
- The first essential for success in accrual accounting is consistency. So, document all policies and procedures for all accounting tasks.
- Have a budget so you can see where you’re going and aren’t just flying blind (with either accounting method you choose).
- Consider outsourcing your accounting to a professional for the easiest solution to ensure consistency, create a separation of duties, and minimize fraud risk.
- Adhere to all Accrual Accounting Best Practices.
When all the above operational practices are in place and the day-to-day processes are executed properly, you will find that accrual accounting is well worth the extra effort. It can simplify your financial management, deliver important insights, and provide greater clarity for your strategic planning.
Developing and implementing an accrual accounting system in a growing business can be a daunting proposition. The transition process can be expected to be challenging. Suppose your business is looking to switch now to accrual accounting but is not ready for a full-scale onsite finance department. In that case, outsourcing accounting is usually the most efficient and affordable alternative.
Despite the inherent challenges in transitioning to accrual accounting, the method offers broad-ranging benefits. It improves the potential to manage the rate of cash flow, provides full transparency of the businesses’ financial position, and enables top management to perform strategic planning in the light of full knowledge of that position. Despite the typical implementation struggles, these payoffs can make switching to the accrual method well worthwhile.
For Outsourced Accounting Services
Accountingdepartment.com can provide your growing business with a full-scope remote accounting department from daily bookkeeping for receivables and payables, to CPA services, and other client accounting services. Reach out today for more information!