We get asked frequently, especially when working with a new or prospective client, “Why should we use the accrual method of accounting?” It’s a good question, especially when they might follow it up with a comment such as, “I manage my finances at home using my checkbook and that works just fine!”
For many people, we agree that maintaining an accurate checkbook can be the cornerstone for effectively managing your personal finances. However, when it comes to managing your business, it’s usually best to record transactions and maintain your financial information using the accrual method of accounting.
So, what is accrual accounting? With accrual accounting, you record revenue when it’s earned and expenses when they’re incurred, rather than waiting until you actually exchange cash (although, sometimes, these things happen simultaneously.)
Some of the benefits of accrual accounting include:
- A much clearer picture of your financial position, including who has claims against your money and vice-versa.
- An accurate capture of both parts of a typical business transaction, even when they happen at different times:
- Part 1: The sale or purchase of a item. This is the “earned” or incurred part mentioned above; and
- Part 2: An eventual cash settlement
- How does our performance this year-to-date compare to the previous year-to-date?
- How is our performance compared to like companies in our industry?
- How efficiently are we collecting cash from our customers?
- What’s our projected cash balance going to be as of a future date?
While properly setting up an accrual based accounting system requires a little front-end work, once it’s set up, it doesn’t require a significant amount of extra time to maintain.
Another important thing to realize if you choose to use accrual accounting is that you can have your cake and eat it too. Most small businesses can elect to use the cash method for tax purposes and still use the accrual method for financial reporting.
Using the cash basis for tax purposes can provide a tax advantage by allowing more flexibility in tax planning. There is nothing remarkable that you have to do in order to enjoy the best of both worlds. You would simply use the accrual method of accounting for your day- to-day financial reporting. Then, at tax time, your tax accountant can make simple calculations to convert your reporting to a cash basis for tax purposes.