Accrual accounting is an accounting method used by companies. The accrual method has a two-fold definition in the financial world. It allows a company to record revenue from goods or services they’ve sold even before they receive payment for them. But it also lets them record incurred expenses before the company makes a payment for them. Basically, earned revenue is recognized in the accounting books no matter when the actual cash transaction occurred.
Most companies provide services, goods, or products before they get paid for them. If a company was paid in cash at the same time they provided their services, accrual accounting would not be necessary. The accrual method allows companies to record the expenses that they have not yet paid but have incurred. And at the same time, they can report revenue in the time period it was earned, even if it has not yet been paid for by their customers or clients. Accrual accounting lets companies balance out their books by recording transactions in the period in which they occurred. For example, using the accrual accounting method, an electrician installs lighting for one of his clients and sends them an invoice for $3,000. The standard is that a client has 30 days within which to pay the invoice. When the bill or invoice is generated, the cost will be recorded in the same reporting period. When the client pays the bill, the receivables will be replaced with cash received.
How Accrual Accounting Works
The basic concept behind businesses using accrual accounting is recognizing economic events by when expense transactions occur instead of when payment is received. Current cash flow is combined with future projections for cash inflow and outflow. The reason it is the preferred method is that it provides a more accurate picture of a company’s financial position.
What are the Qualification Criteria for Accrual Accounting?
Accrual accounting is the standard accounting method for most large companies. Small businesses and individual proprietors use the cash method for accounting. The IRS allows most businesses to choose which accounting method they prefer, accrual or cash. But they must stick with the chosen method. However, businesses that reach a threshold determined by the IRS must use the accrual method. The qualification criteria for using accrual accounting are set by the IRS. In 2021, corporations that averaged $26 million in revenue were required to use the accrual accounting method. In 2022, that threshold was raised to $47 million by the IRS. Secondly, businesses must average this amount of revenue for the three preceding years.
What is the Example of Accrual Accounting?
An example of accrual accounting is an appliance store that sells a stove to a customer on credit. Depending on credit terms and agreements, it can take several months or years before the store is paid in full for the stove. The accrual method allows the store to “account” for purchases as they accrue rather than when they are paid for. This way the store is able to include the stove in their revenue reports currently rather than waiting to record it at a later date.
What are the Advantages of Accrual Accounting?
Accrual accounting allows businesses to recognize and record expenses and revenue when they occur instead of waiting for an actual cash transaction. This gives the business a better view of how it is performing. There are several advantages for businesses, which is why most larger companies choose this method of accounting. A company gets an immediate view of how much money they have coming in as well as how much more they can expect to come in. This allows for more accurate estimates of future expense reports.
Since accrual accounting provides a company with a clearer depiction of resources and their financial responsibilities, they can more accurately assess debts and income. This is more beneficial than waiting for the cash transaction to occur before reporting. The accrual accounting method makes future projections clearer and easier. For companies that are strategizing ways to improve sales or increase revenue, it’s ideal.
What are the Drawbacks of Accrual Accounting?
The primary drawback of accrual accounting is that it doesn’t provide the business with an overview of their current cash flow, but there are some other disadvantages as well. It often takes more qualified staff to manage the accrual method of accounting. It also requires a minimum of monthly reporting. Additionally, it does impact taxes. A company that uses accrual accounting will have to pay taxes on what they report, even if they haven’t yet received the money.
When to Avoid the Accrual Basis of Accounting
Since the cash accounting method is simpler, most small businesses and sole proprietors choose it as their main accounting method. For many businesses, the accrual method offers numerous benefits that are worth the switch. How do you know if you should avoid the accrual accounting method?
- If your business has less than $25 million in annual sales
- If your company doesn’t sell merchandise directly to customers.
What are the Types of Accrual Accounts?
There are four basic types of accrual accounts and adjustments: accrued expenses, accrued revenue, deferred expenses, and deferred revenue. Here are the definitions:
- Deferred Revenue: cash is received before the delivery of goods or services.
- Accrued Revenue: Monies are earned but not recorded because there’s no invoice or no cash payment has been received.
- Deferred Expense: Monies paid before using assets that will benefit more than one accounting period.
- Accrued Expense: Recognizing expenses before cash has been paid for them.
What are the Differences Between Accrual Accounting Method and Cash Accounting Method?
The primary difference between cash accounting and accrual accounting methods is when revenue and expenses are recorded versus when they are paid or received. The cash basis recognizes and records expenses and revenues immediately. The accrual method is based on the anticipation of the revenues and expenses; it doesn’t wait until cash has changed hands. The cash basis is much simpler in nature and incorporates a single-entry system that records cash outflow or inflow. The accrual method is more complex and follows a double-entry system that accounts for every transaction using two columns (debit and credit). Financial statements under the cash basis of accounting cannot be audited. However, financial statements prepared using the accrual basis can be audited.
Does the IRS Require Accrual Accounting for Companies?
Yes, in some specific instances, the IRS will require a company to use the accrual accounting system. If someone is operating a sole proprietorship or a small business, especially in a service-related industry that has no need for inventory, it can operate using a cash accounting system. However, if the revenue of a business exceeds $5 million, it must use the accrual method. Businesses that meet any of these three conditions must use the accrual method per the IRS:
- The business carries inventory
- It is a C-corporation
- The annual average gross revenue exceeds $5 million a year.
What is Modified Accrual Accounting?
Modified accrual accounting is a type of bookkeeping that combines cash basis accounting with accrual basis accounting. It uses the cash method for recording short-term events and uses the accrual method for recording long-term events. The main objective of using the modified accrual accounting method is to avoid the appearance of having a surplus when it is designated for future purposes. Revenue is recognized when it is available to use toward the company’s liabilities. This doesn’t mean the funds are available immediately, but that they will be collected shortly. The normal limit for receipt of funds using this accounting method is one year.