As a small business owner, choosing an accounting method to record transactions is an important decision. Your recordkeeping method affects many aspects of your business, like taxes. You have several options for setting up an accounting system, including the accrual method. What is accrual basis accounting?
What is accrual accounting?
Accrual based accounting is a method you can use to record income and expenses. To use the accrual method, you need some basic accounting knowledge. If you manage accounting with accrual basis, use the same method throughout the life of your business.
With accrual accounting, report transactions when your business incurs them. You record income as you earn it, even if you do not physically receive money. You record expenses as you incur them, instead of when you pay them.
Under the accrual method, record accounts receivable to determine funds due from customers and accounts payable for funds you owe to vendors.
Accounts receivable is money owed to your business, but not yet paid. Accounts receivable helps you keep track of credit you extend to customers. Accounts receivable is also called AR, and entries are called receivables.
For example, you provide a service for a customer and send them an invoice. When you send the invoice, you record the amount as a receivable in your books. Your accounts receivable shows that the customer owes you money.
Accounts payable is money your business owes to other businesses, individuals, and organizations. Accounts payable helps you keep track of credit others have extended to you. Accounts payable is also called AP and entries are called payables.
For example, you buy supplies from a vendor and receive an invoice. When you receive the invoice, you record the amount as a payable in your books. Your accounts payable records show that your business owes the vendor.
How does accrual accounting work?
If you are a new business owner or use a different method of accounting, accrual accounting will take some getting used to. But, learning the accrual method will help you keep accurate financial records. The following is an accrual based accounting example.
Accrual accounting example
ABC Building Supply operates under the accrual method of accounting. The business orders lumber from its vendor, and it is delivered to the store. The store clerks receive the lumber but do not pay the vendor.Using the accrual method, the cost of the lumber is an expense at the time of delivery. The expense is tracked as a payable in the company’s books.
Now, let’s look at this example from the other direction. A customer orders lumber from ABC Building Supply. The company gives the customer the lumber and sends an invoice. The customer does not pay for the lumber at that time.
Under the accrual accounting method, the transaction is considered income despite no funds being exchanged. The income is tracked as a receivable in the business’s books.
With accrual accounting, you use double-entry bookkeeping to record income and expenses. You record two entries for every transaction your business makes. The two entries are equal and opposite.
One entry increases an account and the other entry decreases an account. You increase and decrease accounts by recording debits and credits. Some accounts are increased by debits, while others are increased by credits. Use this guide to know when debits and credits increase an account:
Let’s say you sell a product to a customer and give them an invoice. Since you use the accrual method, you record the income when the customer receives your invoice.
Income is an asset since it adds value to your business. So, the income increases your assets. Looking at the chart above, you can see assets are increased by debits. You debit the income in your books.
After debiting the assets, you need to make another entry. By selling the product, you lose inventory. Inventory is another asset. The loss of inventory decreases your assets.
Assets are decreased by credits, so you credit the inventory. You now have two equal and opposite entries for the transaction in your books.
What is the purpose of accrual accounting?
There a several key reasons a small business might want to use accrual accounting. Depending on your business’s size, you might be required to. If you have more than $5 million in gross sales or $1 million in gross receipts for inventory sales, you have to use accrual, according to the IRS.
Even you don’t have to operate under accrual accounting, the method offers advantages to business owners. The purpose of accrual accounting is to keep track of money you owe and money owed to you. The method makes it easy to anticipate future income and expenses. You can see long-term profitability and make smart financial plans for your business.
Comparing accounting methods
There is more than one way to record your business’s transactions. If you don’t use the accrual system of accounting, you can use cash-basis accounting. No matter which method you choose, you must use the same accounting method each time you make a record.
Consider both accounting methods before choosing to use cash-basis vs. accrual-basis. Each method affects your bookkeeping processes, financial documents, and tax liabilities differently.
The cash-basis method is a little simpler and less time consuming than accrual. The way you record income and expenses in cash-basis is different than accrual.
With cash-basis accounting, you record income when you receive it, not when you earn it. For example, you record income the day you receive a customer’s check for an invoice. You might have sent the invoice weeks ago, but you do not record the income until you have the cash in hand.
You record expenses when you pay them when using the cash-basis method. For example, you record an expense the day you pay an invoice from a vendor. Though you might have been billed weeks ago, you don’t record the expense until money leaves your business.
Cash-basis accounting uses single-entry bookkeeping. You only record one entry for each business transaction. This is easier to do than accrual, which requires two entries for each transaction.
If your business grows big enough, you may need to make a change in accounting method: cash to accrual. If this happens to your business, use Form 3115, Application for Change in Accounting Method.
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Accrual method of accounting at the end of the year
Your accounting method is important when it comes to transactions that happen on December 31 and January 1. These dates cover two different fiscal years for taxes, assuming that your small business fiscal year follows the calendar year. The accounting method affects the timing of reporting income and expenses.
A sale made on December 31 is considered income for that year under accrual accounting, even if a payment was not made until January 1. Income reported in the current filing year increases your business’s tax liability.
Under the cash method, income is reported when you receive funds. In this case, income is received on January 1 of the following year. Income reported in the following year does not affect the current year’s tax liability.
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This article has been updated from its original publication date (8/24/2012).