May 1, 2018
Top 10 Best Practices for Accrual Accounting
Posted by Eric Thomas
If your income always exceeds your expenditures, using cash accounting with no accounts payable or accounts receivable works fine. But if your income isn’t always greater than your expenditures, you need better visibility into what’s happening this month, as well as what’s likely to happen next month. For a fuller picture of your organization’s financial health, you’ll want to manage your finances using accrual accounting.
It records revenue and expenses when they occur, regardless of when payment is actually made or received. This method allows you to better plan for your company’s future financial position.
Here’s how to use it effectively.
- Prepare your annual budget
An annual budget is an absolute necessity when you are using accrual accounting. Simply operating from a cash-on-hand position gives you no visibility into money that you’ve spent or operating costs you’ve incurred, or money that you’ve earned but haven’t received.
To prepare your budget, you’ll want to start by analyzing your year-to-date financial activity. From there, you can either extrapolate out to the end of the year or use the same time period from the prior year if you don’t have much change in your organization.
- Do a monthly review of results against your budget
Ensure that you’re spending the money as you planned, and your revenue is on track to make your goals. In the budgeting process, you should have identified the most important areas to spend money on and the related expenditures required to meet your goals. If you’re not hitting your budget markers, you need to understand why and make changes if need be.
- Prepare a budget forecast
If there are significant differences between the income and expenditures planned for in your budget and your actual cash flow, you’ll want to prepare a budget forecast. If you’re three months into the year and you have a revenue shortfall, a forecast can show you how much you’ll need to cut expenses going forward. Conversely, if your revenue is significantly higher, your related expenditures will also increase. Creating a forecast allows you to make critical decisions from a more informed perspective.
- Follow a close checklist and calendar
This helps ensure accountability and timeliness. Assign ownership and a deadline for each task so that the close is done quickly. Your calendar should have cut-offs for processing payables and receivables transactions, and a reconciliation for―if not all of your balance sheet accounts―your high-risk accounts, which are typically cash, accounts receivable, accounts payables and deferred revenue. It should have a review of your reconciliations and key accounts, a variance analysis for your expenses, and a trending review of the prior 13 months. It should end with the review of your financials with the executive team. The review process should be consistent month to month and occur sometime between the fifth and fifteenth business days.
- Verify expenses and revenue with your operations team
Talk with your operations team to understand what happened during the month. If you’ve got an income statement that’s divided by department, meet with those department heads so they can see the results of your review before you go final, to make sure you have recorded all activities that occurred in the period. They may have knowledge of transactions or deals that you aren’t yet aware of.
- Review your payables and receivables aging monthly
If you have an accounts receivable line item that is six months old and you’ve gotten no response from calls and demand letters, consider writing it off. The last thing you want to do is overstate your receivables and think you’re in a better position than you really are.
If your payables are getting old and you’re not making timely payments, you’ll have issues getting that vendor to provide continuing services. This isn’t always a cashflow-related problem. You may have received an invoice, input it into your system and then lost it. Maybe you’ve accidentally paid another vendor, or the vendor received payment but didn’t apply it properly. If you’re not keeping on top of these two agings, you’re not going to have the information you need to run your business.
- Enforce segregation of duties
This is a simple and effective way to protect your company against fraud and costly mistakes. Simply put, don’t have the person that’s paying your bills reconcile your accounts payable or your bank statement. In addition, the person preparing the reconciliation shouldn’t be the person reviewing the reconciliation.
- Review reconciliations and financial statements
If your company is very small, the owner should be involved in reviewing the reconciliations and the financial statements. Large organizations should have a dedicated staff person prepare the reconciliations, and the accounting manager or controller should perform the review. This is a best practice to prevent fraud, and ensures a second set of eyes on the numbers. The person doing the work will have a hard time stepping back and seeing what they missed, so multiple levels of redundancy will also reduce expensive errors.
- Define your materiality threshold
This is the point above which information that is missing or incorrect impacts decision making in your organization. You need to apply a cost-benefit approach to determining what dollar amount you need to accrue―something that’s different for every organization. Questions to ask when determining your materiality threshold include “If I don’t it accrue this, would it change someone’s opinion on the financial statements?” and “Would the audience for these financial statements want this information included?” Consider looking at a percentage of your revenue to determine the threshold, and then change it as needed.
- Focus on the 20% of accounts that make up 80% of your activity
If you have resource constraints and don’t have the bandwidth to reconcile your entire balance sheet, look at the 20% of balance sheet accounts that make up 80% of your activity. They’ll usually be your high-risk accounts: bank accounts, investment accounts, accounts receivable and accounts payable. These need to be reconciled every month. The same thing holds true for your expense review. If you’ve got a multiple expense accounts, focus on labor and cost of goods sold, which will be the majority of your expenses. Apply the 80/20 rule so that you’re making the best use of your time.
Bonus! Document your processes and procedures
An organization is a living organism, and if you don’t document your internal controls, they can gradually change over time. Whether it’s a drop-in timeliness of the month-end close or an over-eager ratcheting up of your materiality threshold, undocumented changes can impact the operations and efficiency of the finance team. If changes do need to be made, be sure to document them. Just as an outdated budget can hurt your ability to make informed decisions, so too can a finance staff who are not on the same page about how to get things done.
By following these best practices for accrual accounting, you can make a more accurate assessment of your financial position. This will allow you to plan for growth, prepare for contraction, avoid fraud and costly mistakes, and focus your time, energy and money on the aspects of your business crucial to fostering future success.
Find more helpful insights from Armanino’s Outsourced Finance & Accounting team.
Eric has over 15 years of experience in finance and accounting in the private sector and joined the firm in 2014. He served in the capacity as Controller and Director for both public and private companies in the government contracting and professional services industries. His experience includes building finance and accounting organizations, enterprise system implementations, corporate development and restructuring, designing and implementing internal controls, and business process optimization. Eric received a Bachelor’s of Science in Business Administration degree from West Virginia University. He is also a member of the AICPA and CalCPA.