When you start any sort of business how do you know what sort of accounting method you should utilize? If you’re wondering what accrual accounting is and will it work for your business, often it depends upon the type of business you own.
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Is the Accrual Accounting Method Right for You?
Before you decide on an accounting method, consider your business. If you own a basic bar or tavern business with a minimal amount of food or a small home-based gardening or pet sitting business, chances are you’re better off using a cash accounting system since you provide an product or service and get your cash immediately.
In the accrual accounting method, sales and expense transactions are posted or reported when they occur even if cash in or cash out does not occur at the time of the sale or expense.
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How Does This Accounting Method Work?
If we use a flower shop as an example that utilizes the accrual method, an example of how items are posted to the accounting system might be as follows:
Inventory such as flowers, plants, vases, and other items are ordered from your wholesaler. In most cases, if you have a vendor agreement, you are responsible to pay your supplier within 30 days of the receipt of said inventory. In the accrual method, you would record or post to your journal a transaction such as this even though you haven’t paid for the inventory.
Debit your inventory account and credit your accounts payable account.
When it’s time to pay your supplier, even if you do it 10, 15, or 30 days later, you would debit your accounts payable account to clear the charge and credit your bank account showing the cash payment to your vendor.
Sales Revenues Example
An example of an accrual post for sales revenues might be if you have a contract with a local restaurant to supply flower arrangements for the tables. In this case you are the supplier and the restaurant has the 30 day payment timeline.
Credit your sales inventory account and debit your accounts receivable account.
When the restaurant pays you, you would then credit your accounts receivable account to clear the outstanding debt and debit your cash in bank account when you receive the cash.
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Why is the Accrual System Utilized?
The cash accounting method is best for sole proprietorships, home-based businesses, or businesses with little or no inventory. Debits and credits are recorded as soon as the transaction occurs.
In other business where your customers have charge accounts or you have payments due to vendors at a future date, the accrual system gives you a better snapshot of what you owe and who owes you. Expenses are easily identified and categorized and your cash in bank is only debited when you actually receive the cash.
A good accounting system like Quickbooks or Peachtree Complete allows you to set up your chart of accounts through a guided tutorial so when your post transactions they are already set up to debit and credit the correct accounts.
Businesses who have large amounts of accounts receivables should also utilize the accrual method because your monthly balance sheet will show those receivables as an asset, which is a good thing.
There is one drawback to the accrual accounting method. At month or tax year end, if you have posted sales but haven’t received payments on your receivables, your business may still have to pay state sales tax revenues or income tax revenues before you receive the cash. Good cash management is necessary to ensure you have adequate cash flow to cover expenses before you receive payments.