Accrual accounting is the method of recording revenue when earned and expenses when incurred.
The differing philosophy is cash accounting, or recording revenue when receipted and expenses when expensed. To help shed light on the pros and cons of accrual accounting, let’s discuss an example of how both cash and accrual accounting work.
Suppose you provide music lessons to students within the county of your residence. As a music instructor, you occasionally require instruments to be serviced for routine maintenance. In January you provided music lessons for $500, but the customer pays for the music lessons in February. Also, during January you had a routine maintenance occur on some music equipment, costing $300 that you paid in March.
Cash accounting says that you earned $500 of revenue in February and incurred $300 of expenses in March. If this seems odd, then you are understanding a pitfall of cash accounting.
For the same scenario, accrual accounting says you earned the $500 of revenue and incurred the $300 of maintenance expense in January. Why? Because the music lessons were performed during January and the maintenance was also completed in January. This example helps shed light on an advantage of accrual accounting.
The following will shed light on some of the pros and cons of accrual accounting to help you, the business owner, make the decision on what method is best to account for cash within your business.
Pros of Accrual Accounting
As mentioned previously, accrual accounting aims to record revenue when earned and expenses when incurred. As the example above shows, accrual accounting recorded revenue and an expense in January showing a gross profit of $200. Cash accounting would have showed a gross profit in February of $500 and a gross loss of $300 in March.
Accrual accounting can help provide a screenshot at any given point in time as to the financial situation of a business. Comparing months, quarters, and years will provide a clear picture because you won’t be concerned with the delay of payments or expenditure of bills.
Planning also becomes easier because accrual accounting allows you to account for all of your revenue and expenses within the appropriate period. Business owners using accrual accounting can create budgets for expenses and forecast sales to assist with staffing, inventory levels, and other operational areas of concern. One of the other benefits of accrual accounting is that it can also help reduce your tax burden by issuing invoices at the beginning of the year and then at the end of the year.
Another advantage is handling complicated transactions where you may charge amounts to certain GL accounts off of one invoice. Accrual accounting also helps you to avoid overspending by incurring the expense and not overdrafting before payment.
Cons of Accrual Accounting
Accrual accounting can be complex and difficult to manage. Without the knowledge or resources available to manage accrual accounting, confusion and mistakes are likely to occur. Users of accrual accounting have overspent because of not accurately accounting for revenues and expenses.
Another disadvantage of accrual accounting relates to the first, in that the confusion of accrual accounting can lead others to deception of financial statements. Enron and other companies have misused accrual accounting to hide mistakes and weaknesses within their respective financial reports. While this type of accounting can be beneficial, it can also be used to hide fraud.
Accrual accounting can be beneficial to a business with the desire and resources to implement it correctly. Talk to your accountant to discuss the individual advantages and disadvantages of implementing accrual accounting in your business.
By understanding the pros and cons of accrual accounting, you can take the next steps to make changes for good to help your business be more successful.