Although it is possible in certain circumstances to use a hybrid system, businesses generally choose to use one of the two basic accounting methods: cash and accrual. In cash accounting, a business records revenue and expenses as money changes hands. In accrual accounting, the economic event (e.g., the sale of a product or service, an order placed for supplies, a workday logged by an employee) hits the books when it happens, regardless of when it is actually paid for.
Cash-basis accounting is common among startups and small businesses that don’t have many employees or complex bookkeeping systems. For the mom-and-pop shop, cash accounting is just easier. Empty the cash register and count up the sales at the end of the day. When bills are due, record the payments when you write and send the check. It’s like keeping a checkbook.
How accrual accounting works
Larger businesses are much more likely to use accrual accounting. In fact, the IRS requires it for companies whose annual revenues exceed $5 million, and it’s the only method recognized by GAAP. Again, with this method, sales and expenses are recorded when they are earned or consumed, which can be different from when they are paid for. A few examples:
- A magazine publishes an ad in its March issue for a retailer that pays for it in April; the sale is recognized and recorded in March.
- Office supplies are delivered on May 15, and paid for with a credit card upon receipt of an invoice in June. The credit card itself is not paid off until July, but the expense is still recorded in May.
- A business prepays an IT company $3,600 on January 1 for monthly computer maintenance through December 31; the business books a $300 expense each month of the year.
Consider the advantages
As a business grows, accrual accounting has distinct advantages over cash accounting. Even if you haven’t reached the $5 million sales threshold whereupon the IRS requires accrual accounting, you can’t get audited financial statements unless you use the accrual basis. Furthermore, unlike cash accounting, the accrual method more closely matches the numbers to your company’s actual month-to-month performance. That makes it easier to accurately assess income and debts, analyze performance trends, watch for seasonal ups and downs, spot financial plateaus as they happen, and leverage this real-time data to plan marketing strategies and revenue enhancements.
Since accrual accounting generates a record of accrued future income and expenses (receivables and payables), it helps companies understand what they can expect to receive and payout at various points in the future. It also shows if the timing of the two is out of whack and creating a cash crunch, which signals to you that it’s time to rein in receivables or slow down payables, or both. Also, the accrual method, by showing the business’ profit picture in real-time, lays out a baseline for comparisons with future performance that you just can’t get from a cash model. And the financial reports generated by accrual accounting are a must for securing loans, investment, or a buyer.
A minor disadvantage
One of the most important things accrual accounting doesn’t show you (unlike the cash method) is cash flow, but that doesn’t have to weigh against all the positives. The accrual system already is generating all of the data you need to build cash-flow models that will project the company’s cash flow as far into the future as you can enter reliable numbers (which can be fine-tuned as you go). These projections can be used to help company financial planners assess when cash is going to be plentiful or scarce, which in turn helps them plan for equipment purchases, new hires, and loans or investment to shore up the weak patches.
In the private sector, the distribution of businesses operating on a cash basis vs. an accrual basis falls fairly predictably on the spectrum from small companies to larger ones. (Curiously, this is less true in the public sector, but that’s a story for another day.) Given that accrual accounting is more complex than cash accounting and requires more expertise, smaller companies considering making the conversion to accrual might hesitate, or at least wonder what expertise, exactly, is required, and where they’re going to find it. If that talent does not exist on the company’s own staff, an outsourced, on-demand expert or team of experts may be in order. The outsourced finance experts at Paro, for example, can pair businesses with freelance accountants who have the expertise you need and the flexibility to be there for you when you need it.
The right professionals for you
Making the switch with outsourced accounting professionals can give you the expertise you need in setting up your accrual accounting systems to record sales and vendor transactions as they happen, create profit-and-loss statements that show monthly accrued revenues and expenses, and set up receivable and payable accounts accordingly. In addition, a company like Paro can match you with accounting professionals who specialize in your industry, which also means— importantly— that they specialize in the software systems designed for your industry.
With years of experience doing exactly the kind of accounting you need, Paro professionals can work quickly to convert your books to accrual accounting, while offering their services on a scale that fits your company’s needs. If your company is still relatively small, and you require only periodic updates and reviews of your accounts and statements, Paro can give you the talent you need when you need it. And you can focus on running your business knowing you won’t get weighed down with accounting functions yourself, but also knowing you will have the best possible financial information to on which to base your decisions and make your business grow.