Understanding the differences between cash and accrual-based accounting seems like a daunting task for many small business owners. However, after learning the core concepts of what constitutes accrual accounting, understanding how your business transactions flow through the various accounts and ultimately how your financial statements reflect the underlying nature of your business becomes rather intuitive. Even if you are removed from the day-to-day bookkeeping or the month-end close process, having this foundational knowledge will make you more effective at understanding your financial statements.
The basics of accrual accounting
The core tenet of accrual accounting is to recognize expenses when they are incurred and revenues when they are earned. In practice, this means that when a vendor provides a service, the related cost should be recognized, or when a good is purchased and the risk of loss is transferred that good should either be expensed or recorded as an asset. The flip side to this equation also holds true. As you provide services you should recognize the associated revenue that you have earned at that point. As you ship goods to your customers, once transfer of risk is made (typically upon shipment), you should recognize that revenue.
Cut-off refers to the last date for including transactions in a financial statement and is an important concept in accrual accounting. If you have a calendar fiscal year, then your cut off date for annual financial statements is December 31. Business owners know that in practice invoices, payments, reports, and data are sent on a lag. Naturally, this often leads to recording the associated information in the period in which this information is received. However, you can see how this can violate the basic requirement of recognizing expenses and revenues according to the rules outlined above. This is why financial statements need to accrue for transactions that are known to have occurred for which transactions have not already been entered into the accounting system via the standard invoicing processes (both on the receivable and payable side).
Be aware that the timing of when payment occurs is irrelevant in determining whether expenses have been incurred or revenue earned. This is the critical difference between accrual and cash accounting as cash-based accounting only records transactions as funds flow in and out of the bank statement.
Accounting for revenue under an accrual-based system
Understanding the flow of financial data through your accounts is key to visualizing the logic behind accrual-based accounting. Starting with revenue transactions, you need a balance sheet account to hold your earned revenue prior to your customer remitting payment. This account is your Accounts Receivable (A/R) and it is critical to understanding when invoices are recorded to A/R on an accrual basis.
When revenue is earned, the entry to record this transaction is:
Dr. Accounts Receivable (Balance Sheet: Asset ↑)
Cr. Sales (Income Statement: Revenue ↑)
In a CPG environment, this entry is typically made at the time of shipment to the customer as this constitutes when you have transferred the risk of loss to that customer. Notice that this revenue is earned regardless of whether the customer has paid or not, and similarly just because a customer has placed an order does not mean it is appropriate to recognize that revenue, as you will need to wait to fulfill that order.
When a customer pays, then the accounting is as follows:
Dr. Cash (Balance Sheet: Asset ↑)
Cr. Accounts Receivable (Balance Sheet: Asset ↓)
Note that in a cash-basis system this accounting entry flow would be simply:
Dr. Cash (Balance Sheet: Asset ↑)
Cr. Sales (Income Statement: Revenue ↑)
In environments when orders are shipped quickly and there are not long delays then the impact of cash versus accrual can be minimal, however, it is still important to understand the workings behind the scenes.
Under certain circumstances, you may need to accrue for revenue that has not been invoiced. Examples of this typically include long-term projects, installment billing arrangements, or milestone-based billing, where portions of the contract have been fulfilled (either goods or services) but the timing of invoicing will cause a lag. In these cases, you will need an accrued revenue account (or “manual” A/R) account to record revenue based on your cut-off date and temporarily hold these customer balances owed to you until an invoice is generated.
Accounting for expenses under an accrual-based system
In a CPG environment, accruing expenses will be more common than revenue accruals. This is because vendors will often invoice on a lag for their services, payroll periods may not align with cut-off dates, debt repayments will differ from interest calculations, etc. The timing differences between when invoices hit your Accounts Payable (A/P) and when those expenses are actually incurred gives rise to these accruals.
For example, when an invoice is received from a lawyer for legal services provided the accounting entry will be as follows:
Dr. Legal expense (Income Statement: Expense ↑)
Cr. Accounts payable (Balance Sheet: Liability ↑)
However, lawyers often send bills a couple weeks into the following month. To properly record these expenses, you should have an accrued liability account to record these in the month the lawyer provided their service. Thus, the entry in the month incurred would be:
Dr. Legal expense (Income Statement: Expense ↑)
Cr. Accrued liability (Balance Sheet: Liability ↑)
To avoid double counting the expense, this accrual is reversed in the month when the invoice from the lawyer is received. Depending on the nature of your expense accruals you may find it beneficial to setup various accrued liability accounts to track items such as:
- Accrued interest
- Accrued sales tax (note that you would likely want to accrue other tax items
- separately depending on your business structure)
- Accrued legal and professional expenses
- Accrued payroll and related benefits (note that most third-party payroll providers include these entries as part of the process)
- Accrued subscription costs
Accordingly, the best practice is to establish a standard process as part of your month end close that identifies all expenses that have been incurred during the month and compare them to actual invoices that have been received. Keeping a detailed list of these recurring expenses will ensure that you can identify any costs not already recorded and report them based on proper cut off.
First steps in establishing an accrual-based accounting system
Bridging the gap between your current accounting process and a true accrual-based system can be less involved than you may initially realize. Most businesses operate on a hybrid accounting model where certain transactions are recorded independent of payment through their standard A/R and A/P processes and thus small tweaks and adjusting entries to account for timing fluctuations are all that are needed to correct for cut-off.
To identify these areas, first consider the various data sources that flow into your accounting system such as:
- Contracts with customers and vendors
- Operating agreements
- Leases for real estate, equipment, and machinery
- Subscriptions for software
- Sales tax reporting from point-of-sale system
Consider if there are any recurring expense items related to these data sources that currently are only recognized when it is paid. If so, prepare a schedule that details these costs by month and establish a workflow for updating as new contracts are signed or renegotiated.
Secondly, ensure that you have a bookkeeping partner that understands the technical requirements of accrual-based accounting that can assist with establishing workflows and best practices to streamline your financial reporting.
Finally, make sure that your accounting and finance tech stack are setup to facilitate automated recording of your transactions in compliance with accrual accounting.
MyPocketCFO offers these services through their automated month end close process and provides expertise on accrual accounting through their fractional CFO services.
