Accounting is one of the most important—and least exciting—parts of running your business. Business owners have a lot of decisions to make. From the logo and marketing budget to employee benefits and paid leave.
However, to run a successful business, you should prioritize financial decisions. And one of the first you’ll need to make is deciding what accounting method you want to use for recording your expenses and profits.
Accrual-based accounting is one of the most popular accounting methods, and we’ll dive into this financial topic more in this guide to accrual-based accounting.
What Is Accrual-Based Accounting?
Accrual accounting is a process that records an expense or credit when the transaction occurs, rather than when the business pays off the debt or receives payment.
Consider a business that sells hand-made furniture. A customer might commission a custom piece, and the business owner would request a 3-month waiting period to complete the work. With accrual-based accounting, the business owner would record the income from the commission when the contract is signed, even if the customer only pays a deposit or doesn’t pay until the completed piece is delivered.
The goal of accrual-based accounting is to track expenses and income streams as soon as they come in to give business owners a clear picture of the company’s financial situation now and in the future.
With accrual accounting, a business owner can evaluate potential income streams while also considering potential liabilities in the form of future expenses. There is no reason for the business owner to be caught off guard with a forgotten expense.
What Are the Benefits of Accrual-Based Accounting?
The main benefit of this form of accounting is the ease of forecasting. Your business can evaluate potential costs and opportunities to see if it can afford additional equipment or investments.
If a business owner knows that a major charge to the company will occur in March, they might not buy an updated piece of machinery until that cost hits their accounts. The business owner can see into the future and know that there won’t be as much cash in the bank account.
Additionally, some companies use accrual accounting to add tax deductions to the current fiscal year instead of waiting for the costs to hit. This allows them to file more favorable taxes and get more back from the IRS, creating a short-term bump in cash to help pay off the items that they deducted. If you are constantly investing in your business and growing each year, this approach may be a potential option for you.
What Are the Drawbacks of This Method?
There are limitations to what accrual-based accounting can do. For example, some businesses might have cash flow challenges even if they have been making a lot of recent sales. This is because the customers haven’t paid yet, making the business owner “accrual rich but cash poor.” Just because money is coming eventually doesn’t mean a business has access to it now.
Accrual accounting is also considered more complex than other forms of bookkeeping. There are more rules to follow, which might be overwhelming for entrepreneurs who are just starting out. You may be tempted to use an easier management option, which can then become a long-term choice once all of your books and reports are set up.
What Is the Alternative to Accrual Accounting?
Accrual accounting is often the favored form of bookkeeping over cash accounting, where expenses and income are recorded as they occur. Using the same woodworking example above, the business owner wouldn’t record the sale until the customer actually wrote a check for the piece.
While this option is favorable in some cases, it is harder to understand how much money is outstanding through unpaid invoices and even harder to know what funds a business needs to set aside for future costs. (With accrual accounting, that money is already “spent” and unusable even if a check hasn’t been written yet.)
Knowing the difference between cash and accrual accounting can help you choose the best method for your company.
Improve Your Books With the Help of Expert Bookkeepers
If you are new to the world of bookkeeping and have a million other tasks related to starting your business, work with a team that can help you get organized and build a healthy infrastructure with sorted and categorized expenses for the future.
The team at Sunrise has a free, self-service bookkeeping app for sending invoices and recording expenses. This is a great place to start to sort out the receipts for your business. If you want more advanced help and a team of people to help create financial documents and work through a backlog of costs and profits, consider our paid bookkeeping services. We are here to help you get off on the right foot—or at least catch-up on your books if you have fallen behind.