Accrual-Based Accounting

In accrual-based accounting, transactions are recorded not when cash comes in or goes out, but when they are initiated. With this system, you record revenue when you earn it, and expenses when you incur them, irrespective of when the payment is made.

 Let’s take the same example as above, but apply the accrual-based method;

Sales transaction:

You sell carpets worth $100 to your client on the 1st of July and your client makes payment on the 5th of July. The difference in accrual based accounting is that you record the sales transaction on the 1st of July (when you sell the carpets)

 Purchase transaction:

You buy carpets from your vendor for $100 on the 10th of June. But, you make payment on the 6th of July. Here, you record the purchase transaction on the 10th of June itself (when you buy the carpets)

The pros and cons of accrual accounting

Pros

• Accrual-based accounting is the more widely used of the two methods and is used by all large companies.
• Accrual accounting is suited for businesses that sell on credit. You can record transactions and keep track of invoices even if you haven’t received the cash for them.
• You record transactions in the accrual method when they’re initiated. This makes it easy to track what you owe vendors and what your clients owe you at any time.
• You can get a better picture of your financial position through this method. The accrual basis allows you to create financial reports like balance sheets and income statements, that are key to know where your business stands.

Cons

• The accrual basis for accounting suffers from disadvantages too.
• It is not suited for efficient cash flow management. Since transactions aren’t recorded at the same time that cash is transferred, it is cumbersome to know how much cash you have in hand at a given time.
• You need to use double-entry accounting if you follow the accrual basis. This makes things more complicated, as every transaction has to be recorded under a minimum of two accounts. This goes beyond the scope of a cash book, so it creates dependence on accounting software as well as an accountant.

When do you use accrual accounting?

The accrual basis for accounting is suitable when:

• Your business is large, and you generate financial reports like balance sheets and income statements to track your financial position and performance.
• You extend credit to your customers and let them pay you later from an invoice.
• You use a double-entry system where transactions are recorded under at least two accounts.
• You have many employees.
• You deal with relatively large numbers of financial transactions on a daily basis, and you use accounting software rather than a cash book or spreadsheet.

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