Accrual Accounting Method, Explained
Accounting isn’t exactly the most exciting thing to think about as a business owner or financial head, but it is definitely one of the most crucial that you cannot afford to skimp on brain space for! For small businesses, systematic accounting of expenses is essential for helping founders and key stakeholders get an accurate picture to evaluate financial performance.
Bookkeeping Basics to know for Small businesses
Bookkeeping refers to the recording and organising of your business transactions. This not only means recording transactions, but also being responsible for accounts receivable (outstanding invoices a company has), and accounts payable (funds your company owes to others), and payroll.
Your company’s accountant will then use this recorded data to interpret and analyse the financial health of your business.
Accounting Methods for Small Business
When it comes to accounting, there are two main methods of accounting:
- The accrual method, also referred to as accrual accounting
- The cash method, also known as cash basis accounting
The key difference between these two methods is the timing when revenue and expenses are recognised.
What is the accrual basis of accounting?
Accrual accounting matches revenues and expenses to the time periods they were incurred, instead of matching revenues and expenses to the actual timing of the cash flows.
With the accrual basis method, your company records the revenue earned from clients before you have received payment for it. When it comes to accrued expenses, these would be expenses that your company has incurred (such as supplier payments, salaries, monthly subscriptions etc.) that you have yet to pay for.
If your company provides a $10,000 service to a key client and the purchase order is signed on July 1, the accrual accounting method would recognise this $10,000 as being earned on July 1, even if the service takes 2 months to complete and the full cash payment only gets recorded in the general ledger on September 1 later this year. When bookkeeping, this revenue will fall under the accounts receivable account, under the current assets section of a balance sheet.
Examples of reporting revenues under the accrual basis of accounting
Following the previous example, imagine your company performs the following transactions in a month:
- Sent out an invoice for $10,000 for creative design services rendered this month, and payment to be received in 30 days
- Received a bill for $2,500 in designer fees for work done this month, to be paid out in 30 days
- Paid $100 in fees for a bill received last month
- Received $5,000 from a client for a project invoiced last month
|Cash Basis||Accrual Basis|
|Tax Deduction (10%)||$(490)||$(750)|
The table above shows the difference in cash flow between accrual and cash based accounting. It is clear that accrual accounting is more representative of a company’s financial status than cash-based accounting as transactions are recorded when a revenue is earned, or when an expense is incurred, not when it is received or paid out.
For a non-profit, when people donate money to your organisation to support fundraisers, contribute grants, or membership dues, the accrual method will recognise the income when the money is pledged, not when the cash is received by the nonprofit.
For businesses in Singapore, only those whose annual sales do not exceed SGD 1 million are eligible for the cash accounting scheme. That means businesses may claim input tax upon payment to suppliers and output tax when payment has been received from customers. This helps in maintaining a stable cash flow for small businesses.
Meanwhile, those following the accrual-based method should only claim input tax in the accounting period corresponding to the date shown in the tax invoice or when you post or process the tax invoice in your accounting system.
Does accrual accounting apply to small businesses?
As a business owner, a difficult decision you would have to make would be: should you use the cash method or accrual method of accounting?
Small businesses choose accrual accounting to get a better overview of profitability but cash accounting can also benefit early-stage startup businesses. If you own a small business in Singapore, you have the option to use the cash accounting method if you qualify for it. Doing so gives you these benefits:
- Ease in cash flow: you only have to pay tax for money received, not for invoices issued.
- Ease in compliance: businesses on the scheme only need to keep track of when they receive and make payment for their GST reporting.
Advantages of the accrual method of accounting
The accrual basis of accounting is advocated under generally accepted accounting principles (GAAP).
Because the timing of when a client pays for their subscription would not affect your business’ financial records, the more accurate picture of profits and losses throughout the financial period will help your company to better plan out a long-term strategy.
This method tends to provide a more accurate picture of your financial health because it adheres to the matching principle, where your revenues and expenses are matched as much as possible in the net income statement during the same accounting period.
This helps your company ensure consistency in your financial statements. It ensures that the financial position of the business is accurately represented, where a profit or expense is not recognised earlier than appropriate hence affecting the picture of your company’s profitability that you show to important stakeholders.
However, as pointed out by Investopedia, because this method does not actively track your cash flow, if your business is facing a cash shortage in the short term, this might not show up in the accrual accounting method which may be showing that your company looks profitable in the long term.
What is Cash basis accounting?
An advantage of the cash basis method is its simplicity. The cash method of accounting will record transactions on your income statement only when they happen. Small businesses tend to use this method because it makes it easy for them to keep track of their cash flow at all times. At any moment, looking at your bank account’s balance, you would be able to tell how much resources you have left.
When your company receives cash from your customers, only then is revenue recorded. Likewise, only when cash is paid out would you record your expenses.
According to the IRAS, only businesses that have a maximum annual revenue of SGD 1 million can apply for a cash-based accounting scheme. The IRAS will assess if you are eligible for this scheme based on the nature, value, and volume of your taxable supplies.
Do consider that businesses that are approved for the scheme remain in it for three (3) years even if your business exceeds an annual revenue of SGD 1 million within that period. To extend, businesses must apply at least 3 months before your approval expires.
Reporting with Cash Basis Accounting and Accrual Basis Accounting
As a business owner, a difficult decision you would have to make would be: should you use the cash method or accrual method of accounting? What would be the reasons for a small business to use accrual accounting?
Many small business owners choose the cash method of accounting because of its simplicity. For example, if you run a sole proprietorship or are just starting your business, you may feel like you can’t afford or don’t need an accountant at this point in time, and hence choose the simpler method of accounting which is easier to pick up as a new founder.
However, as the business grows, some business owners often find it better to swap to accrual accounting to more accurately track revenues and expenses.
Alternatively, companies may choose to use the hybrid method, reporting both cash income and accruals. When opting for the hybrid method, there are certain restrictions that apply, such as:
- If you use the cash method for reporting your income, you must use the cash method for reporting your expenses.
- If you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income.
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