When it comes to financial record-keeping, the cash method of accounting is the simplest, and one that has deep roots in the Indian financial system. Don’t be afraid of this funny-sounding word ‘accrual’ though. It’s actually a simple concept and one that is almost mandatory for any but the smallest business in the U.S. and elsewhere, or one that does a substantial amount of credit sales.
So what is accrual accounting? Entrepreneur.com defines it like this: “An accounting method that records expenses and revenue when they occur, even if you don’t receive the payment right away. The actual term ‘accrual’ refers to any entry recorded that doesn’t have an equal amount of cash entering or leaving the account.”
For anyone having trouble wrapping their head around that idea, let’s try to simplify. An accrual system of accounting is one that treats a sale on credit as if it were complete upon invoicing, even if the actual payment isn’t received for 30, 60, or 90 days, depending upon the terms. Same goes for an expense.
Here’s a simple example of how accrual accounting works with revenue. Let’s consider that your business provided a service for a client. Maybe you’re a plumber and you unclogged a sink in their breakroom. If you immediately took the bill to the boss man or lady and asked for and received payment, you’d be engaging in cash accounting. With the accrual method, you perform the service, write out an invoice, leave it with the company, and go about your day. As mentioned, you will get a check for the work at some point in the future, depending upon the payment terms already established.
From the perspective of your business and accounting records, the transaction is done and complete, even though the cash for the job isn’t sitting in the account yet and may not get there for weeks. Cash doesn’t have to change hands. The sale is entered into the books when the invoice is generated. There are some downsides to accrual accounting, one of which is a business may end up paying income tax on money it hasn’t actually received yet.
With accrual accounting, expenses work in a similar way. Consider that same plumbing business orders a case of plastic pipe connectors from a wholesaler with which they have a long-standing business relationship. It’s the same idea but from the other side of the desk. Rather than generating an invoice for a service provided, the plumber receives an invoice along with the case of parts. The moment (more or less) he opens the invoice, the billed amount is entered into the books as if he already paid it, though he might not actually write out and mail a check for another two weeks or even a month.
This situation is also the reverse of the revenue example when it comes to cash availability. The money to pay for the parts is still sitting in the plumber’s checking account even though it is considered gone as soon the invoice is recorded. This is also the flipside of the tax issue of paying tax on money you don’t have. In this case, you can deduct the expense from your taxes owed even if you haven’t actually paid it yet. Taken together, the tax advantage/disadvantage probably evens out over the long haul. That’s the plan, at least.
What are the Advantages of Accrual Accounting?
In general, the cash accounting method is only intended for a small business or service company that operates on a cash basis. In the U.S., which has encouraged accrual accounting for years, it is the required method if your business has more than $5 million in annual sales or is structured as a corporation. If you carry inventory, such as with our plumbing example, you must use the accrual method. A business of any size that sells on credit should choose to accrue revenue and expenses. As we’ve seen, the seeming imbalance of cash flow and invoices evens out over time.
The story is different in India, where cash accounting has a long tradition and the concepts of accrual are just starting to be explored. Expect the slow migration of government agencies and private companies towards accrual to continue.
The Bottom Line
If you have any question as to which accounting method would work better for your business, we always recommend talking to a tax professional. They can explain the pros and cons of cash versus the accrual system of accounting.