Understanding Accrual Accounting

As our client base at GrowthLab continues to expand, we are seeing more clients use true accrual accounting for their operations. Many of our small business clients use cash accounting, where revenues and expenses are recorded as cash is exchanged. Accrual accounting, however, records revenues and expenses as they are incurred.

From a sales reporting perspective, this is important because a client may not collect on all of their sales as they occur. However, accrual accounting allows businesses to record and report their sales when they occur, rather than when their customers pay. This is especially useful for businesses that afford their clients terms, and maintain a list of receivables throughout the year.

Examples include:

• Retail businesses that need to know when sales typically occur so they can properly manage inventory levels.
• Service businesses like landscapers that need to prepare staffing and scheduling around busy seasons such as spring and fall cleanups.

Why Accrual Accounting Helps Track Expenses

By using this method for expenses, a client can better track and plan monthly expenses. This also allows a business to properly forecast its cash flow, if they know to expect certain bills on a monthly basis, and when those bills' due dates generally fall. If a client either pays their bills as cash flow allows or is a cash-basis client, this will result in higher expenses in the month(s) when those bills are paid. Common examples where accrual accounting improves reporting include:

• Rent
• Utilities
• Insurance policies
• Year-end reporting

For instance, rent should be recorded as a monthly expense on the P&L. Without accrual accounting, a business might record several months' rent in a single period if they paid late or prepaid rent.

Cash vs Accrual Accounting

Cash and accrual accounting are the two primary financial reporting methods used by businesses.

The difference comes down to how they recognize revenue and expenses.

Cash Accounting

• Revenue and expenses are recorded when a payment is made or received

Accrual Accounting

• Revenue and expenses are recorded when a payment is earned or incurred

Cash accounting is often simpler and works well for businesses with straightforward operations. However, accrual accounting provides more accurate financial reporting and deeper insight into business performance.

In the case of utilities, using this method can be a key indicator for reporting. Utilities may include:

• Gas or oil (heating)
• Electricity
• Telephone

If a client receives a gas bill in February, it may be higher than the one they receive the following month in March, as the weather warms up and less heating is required. That bill is to be recorded as such in February to reflect higher gas usage for that month, which is also key for comparative reporting.

For a cell phone, perhaps a client goes on a trip and incurs additional charges for data usage, roaming, etc. That bill should be recorded as such to provide the client with a report showing the actual expenses incurred for that period. Higher-level accrual accounting would not just record the bill on the bill date, but would actually adjust the expense based on the usage dates on those bills.

At year's end, accruals can be a very important piece to the client's final bottom line for the year. Clients may receive bills in January, and sometimes later, for expenses incurred in the previous year.

Common examples include:

• repair bills
• legal bills
• services bills

Many times, you will also see legal bills that come in for services performed in the prior month. As such, those expenses should also be accrued into the prior period. The same types of adjustments would be necessary if a client pre pays for services. Examples of prepaid expenses include:

• Insurance policies
• Future purchase deposits
• Service deposits
• Event deposits

In these instances, the first step would be to post these items to a Prepaid Expense, which is an asset account, and then expense them at the proper time.

Revenues are recognized when cash is received and expenses are recorded when cash is paid.

Revenues are recognized when earned and expenses are recognized when incurred.

Do I Need Accrual Books Instead of Cash?

Believe us, we get it. Cash accounting is simple. You only record earnings and expenses when cash comes in and goes out, right? We’re not saying cash accounting is bad; it serves its purpose and lays its cards on the table. But for several reasons, many businesses prefer accrual accounting to report their financials, or if push comes to shove in a court of law, there’s a paper trail to back up their income. Using accrual accounting insights, you can keep tabs on your business’ financial health and stay in forward motion. You can make predictions about the business's:

• Value
• Growth
• Potential revenue

Plus, report expenses according to when they occur.  By doing so, you get ahead of schedule, so bills don’t pile up and you know you have to save money if you’re having a low-sales season.

Frequently Asked Questions