The accrual basis of accounting essentially requires you to recognize income when earned and expenses when incurred versus the cash basis of accounting which requires you to recognize income when received and expenses when paid. The accrual basis of accounting affords several benefits for financial reporting over the cash method of accounting. In certain cases, businesses have requirements to utilize the accrual basis of accounting.
Timely Reporting of Income
Because the accrual basis of accounting requires you to report income when the business earns it rather than when paid, your accounting financials reflect the actual month when sales occurred. For seasonal businesses or businesses that have high volume sales periods, a more accurate picture of the actual ebb and flow of sales activity allows you to determine the best months for special advertising campaigns and lets you know which peak times of the year you may need to bulk up on staffing.
Equal Distribution of Expenses Paid in Advance
For large expenses paid in advance, such as liability and property insurance, the accrual basis of accounting allows you to expense the payment proportionately according to the number of months the payment covers. For example, if you pay $6,000 for annual property insurance coverage in January, you expense $500 each month for 12 months rather than recording the entire $6,000 of expense in January when you issue the check.
Equal Distribution of Expenses Paid in Arrears
The accrual basis of accounting also allows you to expense large items that cover several months and the business pays in arrears, such as real estate tax. These are allocations before payment referred to as "accrued expenses." If you will owe $12,000 in real estate tax payable at the end of the year, you can expense $1,000 a month on your accounting general ledger to spread the cost evenly across the year.
IRS Requirements for Using the Accrual Method
If your business generates more than $1,000,000 in averaged gross receipts for the past three years of operations, the Internal Revenue Service requires you to use the accrual method of accounting. However, if your business made $700,000, $1,200,000 and $900,000 in gross receipts for the last three years of operation respectively, the average for those years is $933,333. Because the average amount is less than $1,000,000, you can use the cash method of accounting even though one year had gross receipts of more than $1,000,000.
- “Principles of Accounting”; A. Douglas Hillman, et al.; 1991
- IRS.gov: Revenue Procedure 2001-10
- "Journal of Accountancy": Cash or Accrual?
- IRS. "Publication 538" Page 9. Accessed Oct. 30, 2020.
Kaye Morris has over four years of technical writing experience as a curriculum design specialist and is a published fiction author. She has over 20 years of real estate development experience and received her Bachelor of Science in accounting from McNeese State University along with minors in programming and English.