Last week, we discussed the cash basis of accounting, the simpler of the two major accounting methods.
Whereas the cash basis only records transactions upon the transfer of funds, the accrual method recognizes all financial events with the timing of their cash transactions notwithstanding. In other words, accrual is more immediate, because it records revenue and expenses regardless of when the transaction occurs. The accrual method allows for current inflows and outflows of funds to be reconciled against future expected cash inflows and outflows, thus giving the company a more accurate depiction of its current financial standings.
The lack of a lag in reporting has given the accrual method a reputation as being the more accurate but complex of the two.
Pros & Cons of Accrual Basis
Depending on the business type, companies may be required to utilize the accrual basis for accounting, but there are several other reasons that a company might elect to use this method in lieu of the cash basis.
The accrual method is particularly beneficial (or necessary) for:
- Companies holding inventory (which requires the accrual method)
- Projects with long-term revenue streams
- SEC regulations on all publicly traded companies
- Companies that make sales on credit
- Audit preparation
The complexity of the accrual method requires a bit more consideration when accounting for a company’s finances, but when completed by a seasoned accounting professional, these efforts are straightforward and worth the extra work.
Who Can Use Accrual Basis?
Anyone! However, the IRS requires all companies either publicly traded or making $25 million or more in annual gross receipts to use this method because it provides reliable and precise accounting. Companies earning under that threshold may choose between the two methods, completing the IRS Form 3115 (an application to change accounting method) if they ever choose to switch.
In Summary
Both the cash and accrual basis accounting methods come with their own pros and cons, leaving small businesses with a tough decision when choosing between the two.
To gain a full understanding of the financial implications for your business under each method, speak to a tax professional at DSJ. Call our office at 516-541-6549 and visit our website to learn more.