The key component to accrual versus cash is that you are matching your revenue to your expenses. Basically, recording that revenue when you have earned it and recording those expenses when you have incurred those expenses, instead of it aligning when the cash is actually received and actually goes out.
On an accrual management plan, if we had finished a project in February and we billed the client for $10,000 during that same month, that will show up in February’s financials as revenue. However, we may not receive the payment till a month later. On a cash basis that will show up as revenue for March and not February, because the money was not received until then.
Out of the $10,000 that was billed, $6,000 of it was for labor that needs to be paid out to employees and contractors, on an accrual basis that should be happening in February because that is when the work was done. This will be an expense in February’s financials. If working under a cash basis, this will look like a $6,000 deficit in February when in reality you netted $4,000 worth of income.
Applying This Method to Your Business
This practice becomes very important when looking at potential registration fees for a sports league for example. The money you will be receiving, potentially months before that money is used for expenses for those leagues, does not align because they are used at different periods. This makes it difficult to look at your true margin and true performance on any of those leagues without having those expenses line up with the revenue in the same period.
Project costs is a big portion of this as well. If we look at the event side of things, there are typically many costs leading up to the actual event like: deposits, decorations, food and so on, but the money will be trickling in over a certain period from ticket sales. The most common trend for this is a bulk of sales comes in right before or the day of the event. What this looks like on a cash basis in your bookkeeping is that there are months of expenses, then only a few short weeks of revenue and this can be difficult to evaluate the success of the event.
Having an accrual basis would show you those as a prepaid expense, but not hit your profit loss yet. All that revenue would have been recorded as your deferred revenue, and not hit your profit loss yet until the day of the event. Those costs and revenue would then show up in the same period of your recording making it easier to evaluate your profit margin.