Accrual-basis accounting helps you record your business activity as it happens, even if cash has not yet changed hands. Most businesses use this method rather than cash-basis accounting. The IRS generally lets you choose which method of accounting you use, with some exceptions. When you file your first return, you must report your choice of accounting method and stick with it once you've made your choice.
TL;DR (Too Long; Didn't Read)
Any business can choose to use the accrual method of accounting, but you have to use it if you're a C Corporation, you have inventory or your annual sales revenue is greater than $5 million.
Accrual Vs Cash Accounting
The accrual method of accounting is used in the majority of companies. By this method, you record revenues and expenses as soon as you incur them, even if the money hasn't arrived in your account yet or the bill has not been paid. Compare this to the cash method of accounting, where you only record a transaction when money is paid out or received, and you can see how the accrual method allows you to have a more realistic view of your income and expenses in any given time period. Any business that carries inventory, records bills in advance of paying them in an accounts payable account or makes sales on credit which results in an account receivable, generally should use accrual accounting. A downside of accrual accounting is the lack of visibility into the company's cash flow. Companies typically offset this issue by preparing a monthly cash flow statement.
When You Must Use Accrual
If you operate a sole proprietorship or small business, especially a service-related business that does not carry inventory, you'll be able to use cash accounting as long as your gross annual revenue does not exceed $5 million. Otherwise, you should use accrual accounting. It's compulsory to use the accrual method if your business meets any of the following three conditions:
- You carry inventory
- You are a C-corporation
- Your annual average gross revenue exceeds $5 million per year.
To add color to these conditions, if you offer any credit to your customers and let them pay you later for the purchases, or if your business makes any purchases on credit, you should use accrual accounting. If you manufacture a product, buy goods for resale, sell merchandise or report any inventory that your business has on hand at the end of each year for taxes, the IRS requires you to use accrual accounting.
Exceptions: A Hybrid
In some cases, if a company has inventory, but it represents a very small portion of the business, the firm can use cash-basis accounting for the bulk of its other business transactions while using accrual accounting for inventory only. The IRS allows this method, called the Hybrid method. However, it involves special rules, and income and expenses need to use the same reporting method, whether you choose cash or accrual. In other words, you cannot record your income using the cash method and record expenses with the accrual method. It's best to get advice from a tax accountant if you fall into this category.
What it Means for Your Business
The accrual method includes accounting for all the bills you owe in a payables account, and all the money owed to you, in a receivables account. This gives you a more accurate picture of your company's true profitability, especially in the long-term. If you are tempted to use the cash-basis method of accounting for your business, that's understandable because of the method's simplicity. However, your accounting system won't track outstanding bills due, or allow you to offer credit terms to customers and track that outstanding money. Additionally, your company might look like it's doing very well with a lot of cash in the bank. However, you could actually have a lot of unpaid bills not being tracked, that far exceed the cash in your business.
Cynthia Gaffney has spent over 20 years in finance with experience in valuation, corporate financial planning, mergers & acquisitions consulting and small business ownership. She has worked as a financial writer and editor for several online finance and small business publications since 2011, including AZCentral.com's Small Business section, The Balance.com, Chron.com's Small Business section, and LegalBeagle.com. A Southern California native, Cynthia received her Bachelor of Science degree in finance and business economics from USC.