Define Accrual Accounting

The accrual basis of accounting is one of the two basic methods of reporting income and expenses in use today. Under the accrual method, income is recognized when earned, and expenses are recognized when incurred. Understanding the differences between accrual and cash accounting can help with this explanation.

Two Basic Systems of Accounting

The accrual basis of accounting is one of the two basic methods of reporting income and expenses in use today. The other common accounting method, and the one which is most frequently implemented for personal use, is the cash method of accounting. The difference between these two methods is really a matter of timing.

Simple Cash Method

The cash method of accounting is a pay-as-you-go system which simply keeps track of cash on hand. Businesses relying on this accounting method record income only when the cash comes in and records expenses only when they are paid. While this reporting system is very simple and easy to use, it can also be very misleading. In most cases, the checking account balance of a business on the cash method of accounting will not accurately reflect its financial condition.

Cash Method Can Be Misleading

If a business reporting on the cash method wants to appear near bankruptcy, they can easily pay a stack of bills early to accomplish the desired purpose. If taking out a loan and convincing the bank of ability to pay is the goal, the business can simply shelve some bills until after the reporting period is over. Businesses utilizing the cash accounting method may also manipulate the timing of income, by billing in advance, or asking clients to defer payments for a few weeks or months.

How the Accrual Method Works

The accrual basis of accounting was designed to provide more accurate reporting by recording income when earned and expenses when incurred---regardless of when cash is received or paid. In other words, the accrual method of accounting keeps track of who you owe and how much, as well as the amount that others owe you.

Because of its greater complexity, the accrual system of accounting requires more detail and takes more work to maintain. Most larger businesses find the time and expense of the accrual method to be well worth the effort, however.

Generally Accepted Accounting Principles (GAAP) recognize the increased accuracy of accrual basis of accounting by requiring it in audit situations. As a result, any business in need of audited financial statements relies on the accrual basis of accounting as their accounting method.

An Important Decision

The decision between the cash and accrual basis of accounting carries important tax implications as well. Some businesses choose to report to the IRS on a cash basis while preparing a second set of books (for investors, owners or banks) on an accrual basis. While maintaining two sets of books requires a great deal of effort and is usually only done by larger businesses, the tax savings can be truly significant. Because of the potential savings involved, it is important for any business owner to understand the difference between cash and accrual accounting early on so they can make the best choice of accounting method during the start-up phase of the business.

References

• Keeping the Books: Basic Recordkeeping and Accounting for the Successful Business; Linda Pinson, 2007