Nowadays, accrual accounting is a standard practice. As few companies pay right away for the goods and services they purchase, using this method of accounting allows them to keep track of their transactions, regardless of when cash is exchanged. Keep reading to learn about what accrual accounting is exactly. Discover what the benefits of using accrual accounting vs cash accounting are, as well as concrete examples of its uses for your business.
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What is accrual accounting?
Accrual accounting is one of the two methods of the Generally Accepted Accounting Principles GAAP (the norm in the US) for accounting. Organizations use it to record their expenses and revenues when they occur, rather than when cash is received.
It adheres to the matching principle that states:
- Revenues should be recognized when earned.
- Expenses should be matched with the revenue recorded.
That means that expenses incurred for producing a good or delivering a service are to be matched with the revenue when it occurs, not before (when it is received). It’s helpful to determine your profit and loss over a period of time.
Concretely, it means recording your accounting and financial transactions when the revenue or expense actually happens during the tax year.
For example, let’s say you sell a SaaS subscription where a customer pays $1,200 upfront for the year. While your company receives the money in one transaction, with accrual accounting, you will only recognize a part of the income received ($100) each month. That’s also when the direct expenses linked to this income (servers, etc.) will be recorded.
Payment is one of the key steps of your procure-to-pay process. Accurate recording of your transactions makes it easier to keep track of your company’s cash flow.
Accrual vs cash-based accounting: what are the differences?
While both accrual and cash basis accounting are generally accepted accounting principles (you can use one or the other to calculate your taxes), the way they work is fundamentally different:
- In cash-based accounting, the cash received is what triggers the transactions to be reported.
- In accrual accounting, your revenue and expenses are recorded when they are incurred.
Let’s take an example:
- You order goods from a supplier on June 1st.
- You receive the goods on July 15th and pay for them right away.
The expense will be recorded differently if you use cash-based accounting or accruals:
- On June 1st for accrual accounting, because that’s when the expense happened.
- On July 15th for cash-based accounting, which is when you paid your supplier.
(For the sake of simplicity, this doesn’t take into account when you sell your goods and the matching principle.)
Cash basis accounting tends to be easier to deal with because it’s more straightforward: you record when transactions go in and when they go out. That’s why it’s mainly used by small businesses.
For large and complex businesses, however, cash-based accounting doesn’t give a true reflection of their cash flow and financial health. You can’t draw accurate profit and loss statements as revenues and expenses aren’t matched. It makes it more complicated to calculate your taxes too, as credit extended to customers or by your suppliers can’t be taken into account.
What are the advantages of accrual accounting?
While the cash basis method is easier to use, accrual accounting is the go-to method for many large and small businesses. There are several advantages to using the accrual method:
Produces more accurate financial reporting
Because accrual accounting considers when the revenues and expenses happened, it’s easier to keep track of your cash inflows and outflows.
Thanks to the matching principle, profit and loss can be better monitored when you match them together over a period.
With cash accounting, it’s harder to link your expenses to your revenues and to track your profitability for each of your offers or products.
Businesses that wish to raise capital or borrow from a bank go for accrual accounting as it better displays their profit margins and cash flow projections.
Leverages debts and credits
Today, few businesses go without managing debts and credits as part of their operations. Streamlining your accounts payable process (and your account receivables) is a big part of the job for financial professionals.
With accrual accountancy, accountants can better leverage accounts receivable (what your clients owe you) and account payables (what is due to your suppliers).
Increased visibility over your debts and credits means you can take corrective action were needed to increase your performance.
For example, you can try to negotiate longer payment terms with your suppliers to lengthen your working capital cycle. On the other end, you could decide to offer more generous payment terms for free to your clients to incentivize them to purchase.
Accrual accounting allows you to easily monitor both your accounts receivable and payable and adjust them as needed. A key to unlocking this added performance for your business is to optimize your account payable workflow.
Improves cash flow management
With better cash flow reporting comes better cash flow management. With accrual accounting, accountants and financial professionals can produce more accurate cash inflow and outflow projections.
Accrual accounting keeps track of the business’s assets and liabilities and can leverage them to improve cash flow management.
More cash flow available means finance professionals can decide to repay debt, distribute dividends to shareholders, or make smart investments that will contribute to the company’s future well-being.
Accrual accounting is the gold standard
Overall, accrual accounting is the standard of any organization that wants to grow. Accountants use it as a default as it’s easier for them to report expenses and revenues this way on financial statements.
It’s easier to keep a look at both current and expected cash flow through accrual accounting. Overall, it provides a more realistic view of your financial health.
A small business may want to start with cash-based accounting and move to accrual accounting when it reaches a certain stage of complexity. However, very few companies go from using the accrual method to using cash-based accounting.
Examples of accrual accounting
Now that you’re familiar with the accrual accounting concepts, let’s look at different examples of accrual accounting.
Deferred Revenue
Let’s take a SaaS business operating with a subscription business model. They sell annual access, meaning their clients pay for 12 months in advance. While that’s better for the company’s cash flow, it’s considered a liability on your balance sheet because it’s a future obligation to deliver the good or service.
With accrual accounting, this revenue is received when the client pays, but not cannot be recognized yet because the service hasn’t been delivered. This is the definition of deferred (or unearned) revenue, as accounting recognizes revenue only when it has been earned.
To adhere to the GAAP, the SaaS business can only recognize 1/12th of the total amount every month, when the service has actually been delivered. To respect the double-entry accounting concept, the cash waits in a deferred revenue account.
Any subscription (quarterly, bi-monthly, etc.) or advance payment from your customer is treated this way.
Accrued Revenue
The opposite of deferred revenue is accrued revenue. It happens when you deliver a good or service but don’t get paid for it straight away.
That usually happens in long-term projects where a payment timeline is established and new transactions are unlocked and sent when a milestone is reached.
It’s quite common in construction services and for utility providers. For example, you usually have to pay for your electricity at the end of the month or quarter, once you know how much you’ve consumed.
Your electricity company has provided their services without getting paid but expects you to pay at the next milestone (the end of the month or quarter).
Their accountants will have set up an “accrued revenue” account where your bill is waiting to be paid. Like accounts receivable, it’s considered an asset, because it’s a promise to pay backed up by a contract.
However, statistically speaking, some of their clients won’t pay their bills (at all, or on time). That’s why you need a risk management strategy to mitigate your financial risks.
How can you leverage accrual accounting in your business?
In the example highlighted above, you can see how businesses can make the most of accrual accounting principles by tweaking their payment terms, accounts payables conditions, etc.
At the end of the day, the goal is to optimize your company’s cash flow management. The core work of accountants and treasurers is to make those strategic decisions so your business has a bright and profitable future.
With so many issues facing accountants in 2024, it’s important to focus on two things:
- Streamlining your accounting processes so they’re more efficient.
- Protecting your business from fraud.
98% of US companies were targeted by at least one fraud attempt last year. Thankfully, using software like Trustpair fully eradicates the risk of third-party fraud from your business.
We also contribute to streamlining your B2B payments by running automatic checks on your suppliers’ credentials. Your accounting team can spend their time on higher-value tasks. We’ve helped 200+ companies across the world secure their payments. Their teams are more productive and can focus on financial optimization. Our fraud detection and prevention software makes your suppliers’ payments 100% secure.
Key Takeaways:
The accrual accounting method reports revenue and expenses when they are incurred instead of when the transaction happens in cash-based accounting. It’s a standard for many businesses in the US, as it better portrays a company’s financial health. You can streamline your accounting processes and protect your cash flow by using Trustpair.
