Businesses make use of accrual accounting to get an accurate financial picture of the annual operations of the business. In this type of accounting, the business recognizes revenue and its matching expense at the time of generation and not when the money changes hands during a transaction. Here, the company records its revenue after it is earned and not while collecting money. This gives a clear picture of earnings.
In this article, you will learn some of the general details about accrual accounting and how it works for businesses. Here, we will take a look at the mechanism in simple terms. Then, you will learn about this concept with the help of a simple concept. Finally, we will discuss the major pros and cons of accrual accounting so as to get a better understanding. Hence, to learn more, read on through to the end of the article.
What Is Accrual Accounting?
According to Investopedia,
“Accrual accounting is a financial accounting method that allows a company to record revenue before receiving payment for goods or services sold and record expenses as they are incurred.In other words, the revenue earned and expenses incurred are entered into the company’s journal regardless of when money exchanges hands.”
This type of accounting differs a lot from the cash basis accounting system, according to which the company records revenue after paying for the goods and services (expenses). With the accrual basis accounting system, the company combines one of the two key accounting principles, namely, the matching principle and the revenue recognition principle.
The matching principle is used at the time of using the accrual accounting principle.
According to the matching principle, the company must recognize the expenses in the same period as the revenue they are generating. On the other hand, according to the revenue recognition principle, the company must recognize its revenue after realization or after earning it. In the latter case, the business performs the action and entitles the action to the revenue.
How Does Accrual Accounting Work?
Basically, in the accrual accounting system, the company makes the journal entries while providing the goods and services. It is not making the journal entries while it is making or receiving payments. With this method, the company combines cash inflows and outflows to get a more accurate picture of the company’s current and long-term finances.
With the accrual accounting system, the company tries to make the relationship between revenues and expenses clear. This helps the company get a better insight into its profitability.
According to Netsuite.com,
“It also offers a more accurate picture of a company’s assets and liabilities on its balance sheet. For these reasons, accrual basis accounting is the only method allowed under General Accepted Accounting Principles (GAAP) and is required by the Securities and Exchange Commission (SEC) for publicly traded companies.”
Apart from that, the company records accruals on the company’s balance sheet that act like placeholders for cash events. For example, if you take accounts receivable, it is considered an asset account, which shows the earned revenue of the company, but it has not been paid for. Similarly, accounts payable is the company’s liability account, which reflects the amounts the business owes but has not yet paid.
However, not all companies can qualify for accrual accounting. Only large companies must use accrual accounting if the average gross receipt revenues of the company are more than $25 million over the previous three years. If this is not the case, and if the company does not meet the average revenue requirement, it can choose the cash basis or the accrual, as per its convenience.
Furthermore, regardless of the size of the company, if the company carries inventory or makes sales on credit, it is compulsory for the company to choose accrual accounting.
Example Of Accrual Accounting
According to Business News Daily,
“Under the accrual basis accounting method, income and expenses are recorded when they are accrued, not when the money actually comes in or goes out. Accrual basis is the more common method of accounting, and it’s mandatory for corporations that have gross receipts of $26 million or more in any of the past three years.”
For example, let’s say that the phone bills of a company are $500, paid for thirteen months. Then, the business will consider $6,000 for twelve months this year and the rest $500 for one month next year. In this case, the business recognizes the expenses in the books at the time of payment and receipt. Continuing with the example above, with cash accounting, the business will recognize the entire $6,500 in the same year of the payment (business expense).
What Are The Benefits Of Accrual Accounting?
The following are some of the major pros of accrual accounting which shall benefit you:
- It gives a more accurate picture of the company’s financial condition
- Simplifies complex revenue and expense structures of the business
- Gets fast feedback on expected inflows and outflows
- It is easier for businesses to manage current resources and plan better for the future
- It allows the business to save tax on depreciation
What Are The Cons Of Accrual Accounting?
The following are a few cons of accrual accounting which you must be aware of:
- The system is complex, and it’s expensive to implement
- There are extensive rules and regulations to follow
- This accounting requires more work, and hence a specialist is a must
- The money is shown that is not actually available
- You might pay taxes on income that you have not yet received
Hope this article was helpful for you in getting a better understanding of accrual accounting in general. This type of accounting gives the business a more accurate view of the financial status of the company by recording revenue when it is earned and when expenses are incurred. Thus, the company is matching the expenses with the revenue.
Basically, the company recognizes the revenue and expenses in the same period, which is called the matching principle, and makes use of the double-entry accounting method for recording. Do you have something to add related to accrual accounting? Share your thoughts and ideas with us in the comments section below.