Accrual Accounting - Understanding and Using in Your Small Business
What is accrual accounting? How might it affect your business? Should you use it in your small business? Let's start with a basic definition.
In accrual accounting income and expenses are recorded based on events, not the transfer of actual cash.
The income is recorded when it is earned, not when a payment is received.
Expenses are recorded when they are incurred, even if you have a 12 month payment plan.
So how might this affect your business? Let's look at a few examples.
Recording Income Before Payment is Received A great example would be a sale that is generated with payment terms of Net 30.
In accrual accounting as soon as a physical product has been delivered you would book the revenue.
Your income statement would include the revenue even though you had not received any money.
Sounds great right? Not so fast.
Let's consider the flip side.
Waiting To Record Revenue Even When Payment Has Been Received Doesn't make sense does it? If they paid you, well hey they paid you! But have you earned it? You may be thinking well sure, it's not like I stole the money.
In accounting earned income means that you have performed all the services promised for the money received.
Let's take a prepaid gym membership.
You run the gym, and charge $1,200 per person, payable in advance, for 12 months of membership.
In accrual accounting you would not book the entire $1,200 as income right away.
You haven't delivered the service yet.
Instead you book $100 each month as you provide the service.
The goal of accrual accounting is to reflect the activities of a business at that specific point in time.
* Benefits of Accrual Accounting More accurately matches income and expenses at a given point in time, giving a better picture of the health of your business * Great reminder you still need to provide services to hang onto your cash * Creates a reality check for expenses purchased on credit * Disadvantages of Accrual Accounting You may end up paying taxes on income before you actually receive the cash * Significantly more difficult to mitigate taxes by speeding up or delaying expenses * It's easier to lose sight of the fact that some of your income is not yet money in the bank * Tracking and reporting are more complex than cash accounting It is important to note that accrual accounting may be a requirement depending on the type of business you run, and its legal structure.
In addition, if your business has revenues over $5 million, you may be required to use accrual accounting.
To determine if any of these situations apply to you, be sure to consult a professional.
If there are no requirements, it will be important to consider the benefits, and constraints in relation to your business, before deciding if accrual accounting is right for you.
In accrual accounting income and expenses are recorded based on events, not the transfer of actual cash.
The income is recorded when it is earned, not when a payment is received.
Expenses are recorded when they are incurred, even if you have a 12 month payment plan.
So how might this affect your business? Let's look at a few examples.
Recording Income Before Payment is Received A great example would be a sale that is generated with payment terms of Net 30.
In accrual accounting as soon as a physical product has been delivered you would book the revenue.
Your income statement would include the revenue even though you had not received any money.
Sounds great right? Not so fast.
Let's consider the flip side.
Waiting To Record Revenue Even When Payment Has Been Received Doesn't make sense does it? If they paid you, well hey they paid you! But have you earned it? You may be thinking well sure, it's not like I stole the money.
In accounting earned income means that you have performed all the services promised for the money received.
Let's take a prepaid gym membership.
You run the gym, and charge $1,200 per person, payable in advance, for 12 months of membership.
In accrual accounting you would not book the entire $1,200 as income right away.
You haven't delivered the service yet.
Instead you book $100 each month as you provide the service.
The goal of accrual accounting is to reflect the activities of a business at that specific point in time.
* Benefits of Accrual Accounting More accurately matches income and expenses at a given point in time, giving a better picture of the health of your business * Great reminder you still need to provide services to hang onto your cash * Creates a reality check for expenses purchased on credit * Disadvantages of Accrual Accounting You may end up paying taxes on income before you actually receive the cash * Significantly more difficult to mitigate taxes by speeding up or delaying expenses * It's easier to lose sight of the fact that some of your income is not yet money in the bank * Tracking and reporting are more complex than cash accounting It is important to note that accrual accounting may be a requirement depending on the type of business you run, and its legal structure.
In addition, if your business has revenues over $5 million, you may be required to use accrual accounting.
To determine if any of these situations apply to you, be sure to consult a professional.
If there are no requirements, it will be important to consider the benefits, and constraints in relation to your business, before deciding if accrual accounting is right for you.