Accrual basis accounting involves the documentation of revenue(money earned) and expenses(money spent) in the time the transaction occurs whether or not money is received.
For example, if one pays workers wages at the beginning of the next month(September) for work done the previous month(August) this expense is documented as expenses of the previous month and not of the current.
Similarly, if one pays for a service in advance, it is not treated as income of the present time but rather that of the intended period. For instance, if rent is paid for six months in advance, the landlord would consider the income as income for each month and not of the current period.
Accrual vs Cash Basis Accounting
But why exactly do large business prefer Accrual-basis accounting? How beneficial is it really?
As your business grows, more complex transactions will take place. Cash basis accounting will simply become too basic. Accrual basis accounting is crucial for growing businesses which depend on credit. It will allow your business to record and measure credit owed and owing.
Accrual basis accounting is much more accurate than cash basis accounting in the sense that it is a truer representation of a company’s performance. Business owners are able to see growth, fluctuations or loss over a period of time. Cash basis accounting may show a big boom in income simply because income is only accounted for when received. This is not an accurate representation of the company’s performance as it may very well be on the verge of bankruptcy.
Accrual basis accounting also allows for better analysis which in turn allows you to make better use of resources. Owners are able to use this information to determine what decisions need to be made by comparing seasons of growth and loss based on the activities taking place during that period.
Lastly, accrual basis accounting is much more credible and complies with the Generally Accepted Accounting Principles(GAAP). Internal and external stakeholders use these records to make informed decisions about the allocation of scarce economic resources under their control.
This type of accounting is used mainly by larger, more complex businesses. Accrual basis accounting is very beneficial as it accounts for credit, is an accurate representation of financial performance, allows for reliable analysis and complies with accounting standards.
If you are a business owner you should consult with a CPA Firm for their accounting services and expertise before making the decision to use accrual accounting to decide whether or not this type of accounting is suited for your business.