What is accrual accounting? And why you should use it for your business

If you’re like most small business owners, your accounting process probably revolves around one thing: your bank account balance. You check how much cash you’ve got, pay bills when they’re due, and call it a day. This is the hallmark of cash-based accounting, which works fine—until it doesn’t.

The problem with cash-based accounting is that it doesn’t give you the full picture of your business. It only tells you what’s happening with your cash, not what’s really going on with your revenues, expenses, or profitability. That’s where accrual-based accounting comes in.

Why Accrual Accounting Matters

Accrual accounting provides a clearer, more accurate picture of your financial health by matching income to the period it’s earned and expenses to the period they’re incurred. This allows you to:

1. Track Outstanding Payments: Know exactly who owes you money (Accounts Receivable) and what you owe (Accounts Payable).
2. Understand Profitability: Get a true sense of whether your business is making or losing money in a given period.
3. Attract Investors or Lenders: Most investors and banks require accrual-based financial statements because they’re more reliable.

Despite these benefits, most businesses don’t use accrual accounting because it feels complicated. That’s understandable—it involves terms like "Accounts Receivable," "General Ledger," and "Matching Principle" that sound more intimidating than they are.

But here’s the good news: By the end of this blog post, you’ll know exactly how to start using accrual-based accounting in your business.

Step 1: Understand the General Ledger (GL)

The general ledger is the foundation of accrual accounting. It’s a master record of all your financial accounts, grouped into five major categories:

1. Assets: What you own (e.g., cash, accounts receivable, equipment).
2. Liabilities: What you owe (e.g., accounts payable, loans).
3. Equity: The owner’s stake in the business.
4. Revenues: Income earned from providing goods or services.
5. Expenses: Costs incurred to run your business.

Each transaction is recorded in the GL with two entries: a debit and a credit. This is called double-entry accounting, and it ensures that your books are always balanced. Typically we recommend that businesses hire some kind of bookkeeper to handle this work. Bookkeepers are usually inexpensive but are the backbone of keeping your business organized.

Step 2: Recognize Revenues and Expenses on an Accrual Basis

Here’s where accrual accounting shines: it matches income and expenses to the period they occur, not when cash changes hands. Let’s break this down with examples.

Example 1: Recording Revenue

Imagine you run a marketing consultancy. At the beginning of January, you send a $5,000 invoice to a client for services you’ve already delivered. They don’t pay until February.

• In accrual accounting, you record the revenue in January (when the service was provided), even though cash hasn’t been received yet.
• Journal Entry in January:
  • Debit Accounts Receivable: $5,000 (client owes you money)
  • Credit Revenue: $5,000 (you earned income)

When the client pays in February:

• Journal Entry in February:
  • Debit Cash: $5,000 (you received the money)
  • Credit Accounts Receivable: $5,000 (client no longer owes you)

Example 2: Recording Expenses

Now let’s say you hire a freelancer in January to help with a project. They send you a $2,000 invoice, but you don’t pay until February.

• In accrual accounting, you record the expense in January (when the work was done), even though the cash hasn’t left your account yet.
• Journal Entry in January:
  • Debit Expense: $2,000 (you incurred a cost)
  • Credit Accounts Payable: $2,000 (you owe money)

When you pay the freelancer in February:

• Journal Entry in February:
  • Debit Accounts Payable: $2,000 (you settled the debt)
  • Credit Cash: $2,000 (cash leaves your account)

Step 3: Use the Matching Principle

The Matching Principle is the cornerstone of accrual accounting. It ensures that revenues and related expenses are recognized in the same period, providing a clearer picture of profitability.

Example: Matching Revenue and Expenses

Let’s say you run an ad campaign in December to generate sales in January. The ad agency charges you $3,000, which you pay in December. Under cash-based accounting, this expense would show up in December, skewing your financial picture.

In accrual accounting, you’d record the expense in January (when the revenue from the ad campaign is earned), ensuring the expense matches the income it helped generate.

Step 4: Set Up Your General Ledger for Accrual Accounting

To implement accrual accounting, your general ledger needs accounts for:

1. Accounts Receivable (AR): Money owed to you by clients.
2. Accounts Payable (AP): Money you owe to vendors.
3. Deferred Revenue: Payments received for work not yet completed.
4. Prepaid Expenses: Payments made for future expenses (e.g., insurance, rent).

These accounts allow you to track income and expenses independently of cash flow.

Step 5: Use Accounting Software

Manual accrual accounting can be daunting, but tools like QuickBooks, Xero, or Wave automate much of the process. They:

• Help you create invoices and track AR.
• Record AP and remind you of due payments.
• Generate financial reports like the Profit & Loss Statement and Balance Sheet automatically. Ensuring these reports are accurate and available is vital for business planning activities like creating forecasts.

Why Accrual Accounting Sets You Up for Success

By switching to accrual-based accounting, you’ll:

1. Gain Financial Clarity: Understand your true profitability in any given period.
2. Make Smarter Decisions: Know when to invest, cut costs, or adjust pricing.
3. Stay Compliant: Many tax authorities require accrual accounting as businesses grow.

Accrual accounting isn't easy but it's definitely worth it. Again, hiring a bookkeeper can help you make sure that you're following the correct steps. Sites like WeHire can source great bookkeeping talent at low costs.

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