Why Do Some Businesses Use an Accrual Basis of Accounting?
Most businesses use the accrual method of accounting, reports "Entrepreneur." This method of accounting involves recording business income when invoiced, and deducting expenses at the time of billing. For example, the accrual method records sales when the sale occurs, irrespective of when the customer pays, and records the cost of goods and services at the time of purchase, irrespective of when you issue payment.
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Benefits
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The accrual method of accounting recognizes incomes and expenses as soon as they are known with reasonable accuracy regardless of when there is a cash exchange. A sale on credit is a good example of accrual accounting: Record the sale in the books at the time of invoicing, not when you receive cash. Similarly, record expenses such as a worker's wage when the worker logs in and not when the worker cashes the paycheck.
Function
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The primary advantage of accrual accounting is that it gives a more precise picture of the flow of business income, debts and of the operations of business on a regular basis. The method allows businesses to match income against expenses for a given period and accurately assess the overall management performance and profitability of operations. Recording financial transactions as they occur also facilitates better trend analysis, which allows aids strategic planning.
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Considerations
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The use of accrual accounting in business depends on a number of factors. Generally Accepted Accounting Principles, known as GAAP, makes it obligatory to use this method if the organization is structured as a corporation and its annual sales exceed $5 million. The IRS also requires the use of accrual accounting if the business, be it a small retailer or large manufacturer, handles inventory. The accrual method is also favorably recommended for businesses that operate credit sales.
Warning
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One of the dangers of using accrual accounting is that it can lead to inaccurate representation of the business' cash flow. The business' ledger, for example, may be showing sales worth thousands of dollars, while, in reality, the business' cash reserves may be empty, as customers may not have paid yet. Accrual accounting processes requires a recording of two separate transactions, one for the sale and one for the receipt of payment. This dual recording adds complexity to the method.
Tax Implications
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Under accrual accounting, since you record transactions when they incur, you may pay taxes on incomes before you receive payment; you can only deduct expenses in the year the expense occurs, even if you pay for the expense in advance. Conversely, taxes on the income you receive in advance are not due for payment until the time the income is invoiced, and you can claim expenses when you incur the even if you delay payment.
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