Cash vs. Accrual Accounting Systems: Which is Better for Business and Tax Planning?

[Part 2]

Many of our clients have a common question, which accounting system is better, and when to use. This article discusses the workings of Accrual Accounting, their pros and cons

The Accrual Method of Accounting

Accruals are revenues earned or expenses incurred that affect a company's net income on the income statement, even though the related cash transactions have not yet occurred. They also impact the balance sheet by involving non-cash assets and liabilities.

Example: If a company performs a service but has not yet received payment, the revenue from that service is recorded as an accrual. This ensures that financial statements accurately reflect the company's financial position, even if payment has not been received.

Key Elements of Accruals

• Accounts Payable (A/P): Money owed by the business to vendors or creditors.
• Accounts Receivable (A/R): Money owed to the business for services provided.
• Other Accrual Accounts: Accrued tax liabilities, accrued interest earned or payable.

Key Takeaways

• Accruals are necessary for any revenue earned or expense incurred where cash has not yet been exchanged.
• They enhance the quality of financial statements by providing information about short-term credit extended to customers and upcoming liabilities to lenders.
• Accruals and deferrals form the basis of the accrual method of accounting.
• This method is preferred according to Generally Accepted Accounting Principles (GAAP).
• Accruals are recorded through adjusting journal entries at the end of each accounting period.

Understanding Accruals

Accruals record revenues and expenses that have been earned or incurred but not yet documented in the financial statements. This can include unpaid invoices for services provided or expenses incurred but not yet paid.

Accrual Accounting Principles:

• Revenue is recognized when earned, regardless of when payment is received.
• Expenses are recorded when incurred, regardless of when they are paid.

Example: If a service is provided in December but payment is received in January, the revenue is recorded in December. Similarly, if expenses are incurred in December for a service received in January, the expenses are recorded in December.

The Accrual Method of Accounting

Accruals and deferrals are fundamental to the accrual method of accounting, which GAAP prefers. Adjustments are made for revenues earned but not recorded and expenses incurred but not recorded, using adjusting journal entries at the end of each accounting period.

Benefits:

• Improves the quality of financial statements by including non-cash transactions.
• Records short-term liabilities and expected cash revenues.
• Allows recording of non-cash assets, like goodwill.

Double-Entry Bookkeeping and Accruals

In double-entry bookkeeping:

• The offset to an accrued expense is an accrued liability account (balance sheet).
• The offset to accrued revenue is an accrued asset account (balance sheet).
• Adjusting journal entries for accruals impact both the balance sheet and income statement.

Recording Accruals

Income Statement and Balance Sheet Entries:

• For revenue from services provided but not yet paid: Debit "accounts receivable" and credit "revenue" on the income statement.
• For incurred expenses not yet paid: Debit "expenses" on the income statement and credit "accounts payable."

Accrual accounting ensures a company's financial statements provide a comprehensive and accurate view of its financial status, reflecting all earned revenues and incurred expenses, whether or not cash transactions have occurred.

When to Use Accrual-Basis Accounting

Accrual accounting is ideal for larger businesses with complex financial activities. It is particularly useful when:

• Accepting or Making Credit Card Payments: Payments take time to process and post, which accrual accounting can accurately track.
• Tracking Assets and Liabilities: It distinguishes between various assets (cash, checks, investments, inventory) and liabilities (unpaid expenses) with up-to-date records.
• Ensuring GAAP compliance:?Public companies within the U.S. must adhere to the?Generally Accepted Accounting Principles , or GAAP, as decided by the Financial Accounting Standards Board (FASB ). Therefore, such businesses are required to use accrual-basis accounting, as it meets GAAP standards.

Additionally, accrual-basis accounting offers a complete and accurate picture that cannot be manipulated. When evaluating a company based on exactly when cash is on hand or paid out, it is easier to misconstrue the financial state of a business. The accrual-basis approach forces everything to be accounted for in a timely manner.

Legal Obligations from IRS

The Internal Revenue Service (IRS) allows most small businesses to choose between the cash and accrual method of accounting, but the IRS requires businesses with over $25 million in average annual gross receipts from sales for the 3 preceding tax years to use the accrual method.

Internal Revenue Service. "Publication 538 (01/2019), Accounting Periods and Methods." Accessed Dec. 21, 2020.

Businesses must use the same method for tax reporting as they do for their own accounting records.

Some businesses may find a modified cash-based accounting system works best. In this system, accrual accounting is used for long-term assets, and a cash basis is used for short-term assets.

Downsides of Accrual Accounting

Despite its accuracy and reliability, accrual-basis accounting has some drawbacks:

• Complexity: It requires detailed record-keeping, which can be challenging for those not well-versed in this accounting method.
• Time and Cost: Maintaining extensive records and regularly updating them can be time-consuming and expensive, potentially necessitating outsourcing or software upgrades.

Overall, while accrual-basis accounting is beneficial for larger businesses, it may be too costly and complex for smaller ones.

Choosing Accrual Accounting:

• More accurate picture of financial health: Accrual accounting reflects upcoming obligations (accounts payable) and revenue earned but not yet received (accounts receivable). This provides a clearer idea of the company's true financial position.
• Better informed decision making: By matching revenue with expenses when they are incurred, accrual accounting allows for a more accurate assessment of profitability. This insight is crucial for strategic planning and financial management.
• Compliance with regulations: Accrual accounting is the mandated method by Generally Accepted Accounting Principles (GAAP) and required by the Securities and Exchange Commission (SEC) for publicly traded companies.
• Improved transparency: Accrual accounting fosters transparency by showing a more complete picture of the company's financial activities. This can be beneficial for attracting investors and maintaining trust with stakeholders.