A Case for Accrual Basis Accounting

So, you launched your RIA and now have a laundry list of to-dos and decisions to make. One of those tasks is keeping a set of books; the accompanying decision is whether to use an accrual or cash basis accounting.

What Is GAAP and Why Does It Matter?

Accrual basis accounting is considered the standard for GAAP (Generally Accepted Accounting Principles). GAAP is a framework of accounting standards, rules, and procedures defined by the professional accounting industry; these principles have been adopted by nearly all publicly traded US companies.

Why Accrual Is Typically the Better Choice

As a financial planner, you may notice your state regulations require GAAP for your financial documents. By default, that means you must use accrual basis accounting.

However, that's not the only reason to choose accrual basis accounting over cash basis accounting. However, before we delve into the reasons why the accrual method surpasses the cash method, let's first examine the key differences between the two.

Cash vs. Accrual: The Core Difference

Whereas cash basis accounting is a method of posting income and expenses as they occur, accrual accounting is a method of posting income and expenses when they are earned or incurred.

Take, for example, your billing practices for AUM income. It is common practice to invoice your clients quarterly in advance. If you use the cash basis accounting method, the money is posted as income on the date it is received. If you use the accrual accounting method, on the other hand, earned income is posted across the months in which the revenue is actually earned.

Scenario A: Cash Basis

If you receive $9,000 on January 5 for the 1st quarter billing ($3,000 per month for January, February, and March), your cash basis accounting financial records will show a large income of $9,000 in January and nothing for February and March.

Scenario B: Accrual Basis

Using the same scenario but with the accrual accounting method, your financial records would instead show $3,000 per month in January, February, and March.

With cash basis accounting, the $9,000 received for your services for the entire first quarter (January, February, and March) is posted in its entirety on January 5: the date you received it. With accrual basis accounting, the $9,000 is instead split into three $3,000 payments and posted in January, February, and March—the months you actually earned that revenue.

Expenses Follow the Same Rule

The same holds true with expenses. Say, for example, that in January, you pay $1,200 for technology that you will use all year. If you use the cash method, this expense will only be reflected in January, the month in which the expense occurred.

If you use the accrual method, on the other hand, you can accurately reflect the fact that you use this technology throughout the year by spreading that expense over all twelve months—$100/month for January through December.

Why Accrual Gives You a Clearer Financial Picture

Why is this to your advantage? Because when you can actually see your income and expenses allocated to the months in which they are respectively earned or spent (versus when they occurred), you are able to match expenses and income in the correct time frame. Budgeting becomes more meaningful as you see the true ebb and flow of your finances.

Cash vs. Accrual: Quick Comparison Table

To summarize, let’s look at a comparison between the cash and accrual methods of accounting.

Source: Congressional Research Service

Check Your State’s Requirements

Of course, the decision to use cash basis or accrual basis accounting may not be entirely yours; your state’s regulatory requirements may require you to use the accrual method.

It is therefore essential to be aware of your state’s regulatory requirements, as these become a compliance issue when your books are subject to audit. While cash basis accounting is arguably easier, you may be required to make the change to accrual basis accounting if your state requires GAAP. If you work with a CPA, be aware that they may not be familiar with compliance requirements. It is essential to communicate with them to ensure compliance with your state and/or SEC regulations.