Key Takeaways
- Accrual accounting records revenues and expenses when they occur, not when cash changes hands.
- Businesses with inventory are typically required to use accrual accounting.
- The method matches revenues with expenses even if cash transactions are delayed.
- Accrual accounting offers a more precise view of business finances than cash accounting.
- Credit purchases add complexity, often necessitating the use of accrual accounting.
Businesses with inventory or those selling on credit are often required to use accrual accounting to present an accurate financial picture. Unlike cash accounting, accrual accounting records revenues and expenses when they occur, not necessarily when cash exchanges hands. This method provides a more precise and current representation of a business's financial status, and this is crucial for understanding operations and making informed decisions.
According to the IRS, small businesses can choose their accounting method, but accrual accounting is often mandatory for larger businesses or those with complex operations. Most businesses use accrual accounting, while individuals and small businesses use the cash method.
Understanding Accrual Accounting for Businesses
Accrual accounting is based on the idea of matching revenues with expenses. In business, many times these occur simultaneously, but the cash transaction is not always completed immediately. Businesses with inventory are almost always required to use the accrual accounting method and are a great example to illustrate how it works. The business incurs the expense of stocking inventory and may also have sales for the month to match with the expense. If the business makes sales on credit, however, payment may not be received in the same accounting period. In fact, credit purchases are one of the many contributing factors that make business operations so complex. This is why the accrual method was adopted.
With global operations and the increasing intricacy of business, accrual accounting helps to show a precise, current picture of any business. If cash accounting is used, businesses, such as furniture stores, that sell on credit are often not able to report sales until all the money is actually collected, although the sale was made and is reasonably expected to be paid at a future date. It makes more sense for the business to accrue the sale and the cost of goods sold when the furniture leaves the store.
The Bottom Line
Businesses involved with inventory are generally required to use accrual accounting. It matches revenues with expenses when they occur, not when cash exchanges hands.
The IRS allows small business taxpayers to choose between cash or accrual methods, but they must remain consistent with their choice. Accrual accounting provides a more accurate and current picture of business operations, especially for those selling on credit.