What is Accrual Accounting and Does Your Business Need It?

Let’s start with the P&L -- the Profit and Loss Statement, AKA the Income Statement. The P&L tells us about the performance of a business. After each month (or quarter or year) owners and perhaps others want to know how the business performed. How did it do? How much profit or loss? How much compared to the prior month? The same month one year ago? How well did the business do compared to the competition? Compared to the budget?

Let’s think of the P&L as a scorekeeping report. It reports on the success (or lack thereof) of a business by netting revenue against expense to tell us how much net income or loss occurred during the month. Here’s the tricky part: there are different ways to keep score, different ways to define revenue and expense. The two most common methods of accounting are cash basis and accrual basis.

Cash Basis

• Revenue increases profits when cash is received – not necessarily when the service or product is provided. Expenses decrease cash is paid.

• Best for small simple business with insignificant amounts of inventory, receivables and payables.

Accrual Basis

Revenue increases profits in the month when the service or product is provided – not necessarily when the cash is received. Expenses decrease income when a resource is used, not necessarily when cash is paid.

• Best for businesses with any of the following: substantial inventory, receivables and payables. Also very useful for businesses that want to borrow or bring on investors or eventually sell the business (hint: investors and lenders are often more generous when they see solid monthly accrual financial statements).

• Sometimes the IRS requires the accrual method if a business: carries substantial inventory, is a large company as defined by the IRS, or for a few other reasons. Businesses can typically use one accounting method for their internal books and another for the IRS – tax accountants know how to convert from method to the other.

This might help you wrap your mind around the benefits of accrual accounting: Good December Company makes most of its sales in December, so at the end of the December folks are anxious to know how it went. December sales were $800,000: $600,000 was collected in December and $200,000 remained due from customers at the month-end, which is normal for this business. Expenses were $500,000, all paid in December.

Cash Basis - December P&L Summary $600,000 Revenue 500,000 Expense $100,000 Net Income

Accrual Basis - December P&L Summary $800,000 Revenue 500,000 Expense $300,000 Net Income

Accrual basis does a better job of showing us what really happened in December. It really was a $300,000 profit month, there was just a lag of $200,000 in payments from customers. Cash basis shows less net income in December and more in January, when the cash is collected. These are timing differences and accrual accounting knows how to set aside these differences to produce financial statements that make more sense!

As your business grows and becomes more complex, accrual accounting can help you – and potential inventors, lenders, and so on - better understand what’s going on in your business. We suggest: whatever accounting method you use and whomever does your books, make sure you keep good reliable monthly financial statements for the overall health and success of your business.

Please know this blog post contains no tax, accounting, nor legal advice. Our posts are intended to be informative and useful for business owners. And we want you to know!