Many self-employed people have no skill at accounting, in fact, are downright lousy at it.
This is a fairly big problem because, as we've mentioned in this space before, being self-employed means effectively running your own business. You are a one-person sales team, looking for new clients 24/7. Perhaps you run your own website and social media accounts.
You're also your own accountant and, like many self-employed people, probably not a particularly good one.
Which is why, like so many others who work for themselves, you've never heard of accrual accounting.
What Is Accrual Accounting?
Accrual accounting is one of the two primary methods of bookkeeping. Under this system a business records a gain or loss when it agrees to a transaction or otherwise has a financial event. This is as opposed to cash accounting, which records income and losses when money actually changes hands.
Under accrual accounting a company records four main forms of transactions:
• Accrued Revenues - Cash or non-cash assets (including services) that the company is formally owed, but which it has not yet received. This is when a company sells something on credit, to receive payment later .
• Immediate Revenues - Cash or non-cash assets (including services) that the company receives as soon as it confirm the debt. This is when a company sells something and receives payment immediately.
• Accrued Expenses - Debts in either cash or non-cash assets (including services) that the company formally owes, but which it has not yet paid. This is when a company purchases something from a client on credit to be paid later.
• Immediate Expenses - Debts in either cash or non-cash assets (including services) that the company pays as soon as it incurs. This is when a company buys something and pays for it immediately.
Most formal businesses use accrual accounting while individuals and sole proprietorships typically use a cash accounting method. The IRS requires that any business with more than $5 million in sales or $1 million in gross receipts per year use this method.
How Does Accrual Accounting Work In Practice?
Let's say that on Aug. 1 Parker's Photos closes a deal to sell $50,000 worth of camera equipment to Morales Art. It will deliver the product and accept payment on Dec. 1.
• On a cash accounting basis, Parker's Photos would record $50,000 of income on Dec. 1, when it received the money.
• On an accrual accounting basis, Parker's Photos would record that $50,000 worth of income on Aug. 1, once it was officially owed the money.
The difference in approaches can lead to two very different sets of financial reports. Say that in September of that year someone reviewed the books for Parker's Photos. Under cash accounting this auditor wouldn't know that the company had $50,000 coming in the door. An accrual accounting basis would reflect this fact, showing that Parker's Photos has a credit worth $50,000 from Morales Art due in December.
This works the other way as well. Say that on Sept. 1 Parker's Photos agrees to buy six new cameras, one a month for the next six months at $10,000 each. On an accrual accounting basis the company would record the full $60,000 liability on Sept. 1.
Why Use Accrual Accounting?
In a nutshell, accrual accounting presents a more accurate and complete record of a company's financial position.
Take our example above. After the deal with Morales Art, Parker's Photos is now functionally worth an extra $50,000. It is owed this money and will collect it in time (presumably). Yet under a cash accounting basis anyone reviewing the company's books in September wouldn't see that information. Accrual accounting will reflect this incoming cash flow.
More importantly to the IRS, cash accounting would delay Parker's Photos paying its taxes.
Every company pays its taxes four times per year. Accrual accounting means that a company pays taxes on the money that it has earned, not necessarily the money that it has collected. In this case, that would mean that Parker's Photos would pay taxes on the $50,000 from Morales Art in its third quarter (Sept. 15) estimated tax payment. A cash accounting basis delay that until Jan. 15.
The importance of accrual accounting grows with an organization's complexity. Small companies (or individuals) tend to have relatively few credits and debits at any given time. As a result, cash accounting will provide a more-or-less accurate record of their financial position.
Larger companies, on the other hand, typically will have hundreds or thousands of different cash flow streams at the same time. A cash accounting basis will not record any of these debts still unpaid or any of the credits currently uncollected, potentially creating a deeply inaccurate view of the company's financial position.
Take, for example, a company with $1 million in debts not yet due and $500,000 in cash on hand. On a cash accounting basis, this company will look like it has half a million dollars in liquid capital on hand. Only an accrual accounting basis will reflect the vast difference between the firm's debt and its ability to pay.
Accrual accounting allows companies to understand their total financial position once they account for all debts and credits… and lets other parties understand that as well.
Uncertain Accounts in Accrual Accounting
Astute readers will quickly note the uncertainty built into accrual accounting. Under this model, companies record profits they haven't actually collected and debts they don't yet completely know they'll have to pay. What if things don't work out?
Returning to case above, for example, say that Parker's Photos agrees to buy $60,000 worth of cameras, but the vendor never actually delivers on the contract. Parker's Photos would be absolved of its responsibility to pay (since it never received the product) but has already reported the expense on its balance sheet.
In this case, the company would make the reverse claim once it discovers the problem. Here, after Parker's Photos resolves its dispute with the vendor it would claim a $60,000 income on its balance sheet at the time of the dispute resolution. This is the same as having a debt forgiven; the company is richer by the amount it won't have to spend.
The reverse is also true. If a company records a sale but the customer reneges on their contract, that company will enter the new event as a loss in the same amount.
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