What is Accrual Accounting?


When you start a business, you need to choose an accounting method for bookkeeping and for reporting your income and expenses to the IRS on your tax return. Two of the most popular ways to do this are the cash method and the accrual method.

When most people think of accounting, they imagine the cash method, which involves recording a payment when it is received and an expense when it is paid. It helps businesses keep on top of their cash flow because it is an up-to-date record of cash on hand.

The cash method is intuitive for many business owners, but it has some negative aspects and can create complications when filing taxes. If you use a calendar year to file taxes, you may run into a tricky situation if you invoice an income at the end of one year but don’t receive payment until the beginning of the next year.

When you start a business, you need to choose an accounting method for bookkeeping and for reporting your income and expenses to the IRS on your tax return. Two of the most popular ways to do this are the cash method and the accrual method.“The same goes for expense checks,” states Caron Beesley, a contributor to the U.S. Small Business Administration’s “Managing a Business” blog. “If you make a purchase in December but the supplier doesn’t cash your check until January, you can’t claim that deduction in the year that you wrote the check.”

Furthermore, depending on how your business generates revenue, you may create an inaccurate picture of its finances through cash accounting. Some businesses generate a large portion of their income at the end of the year during the holiday season, and if they do not collect all their payments before Dec. 31, they may underreport their profits for the year.

The accrual accounting method is intended to help avoid these problems by matching income and expenses to the correct year. With this method, you record income when the sale is made, regardless of when the payment arrives.

“Generally, you include an amount in gross income for the tax year in which all events that fix your right to receive the income have occurred and you can determine the amount with reasonable accuracy,” according to the IRS.

The IRS requires that you report the gross income on one of the following four dates, whichever comes earliest.

The options are:

  1. The date the payment is received.
  2. The date the income is due to you.
  3. The date you earn the income.
  4. The date the title has officially passed.

Likewise, expenses are recorded when you receive the goods or use the service, even if you have not yet paid for them. Recording payments and expenses before you receive or pay for them may seem strange, but it can actually be a more useful and accurate method of business accounting than the cash method.

“Instead of showing what cash you have on hand, the accrual method gives you a better idea of what you earn each month (as opposed to the cash method, which only records payments when they are made),” states Beesley. “Of course, the downside is that you get a less than accurate representation of cash flow (although a cash flow forecast and statement can help with this).”

The accrual accounting method doesn’t just help you identify the correct deductions to take in each tax year, it may even be required by the IRS. Although most business are permitted to choose whichever accounting method they prefer, the IRS requires use of the accrual method for businesses that must include inventory to accurately account for their income. There are some exceptions to this, which can be found at https://www.irs.gov/publications/p538/ar02.html#en_US_201212_publink1000270636.

Whichever method you choose, it is important that you stick with it. The IRS generally requires businesses to continue using the same method used on the first tax return, unless it specifically requests a change in method.

“You must use the same accounting method from year to year,” states the IRS. “An accounting method clearly reflects income only if all items of gross income and expenses are treated the same from year to year.”

The IRS outlines cases in which approval is required and provides instructions for obtaining approval by filling out Form 3115 at https://www.irs.gov/publications/p538/ar02.html#en_US_201212_publink1000270768.

If you would like to choose the best accounting method for your business, obtain help changing your accounting method or find answers to other business accounting questions, your financial institution is your best resource.

 

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