What Is Accrual Basis Accounting?
The method of accounting that measures the performance and position of a company by recognizing economic activity regardless of whether cash transaction occurs is called Accrual Accounting.
Economic activity is recognized by matching revenues to expenses (the matching principle) at the time in which the transaction occurs rather than when payment is made or received. This method offers a more accurate picture of a company’s financial condition by allowing current cash inflow and outflows to be combined with future expected cash inflows and outflows.
For most companies, other than very small business, accrual accounting is considered the standard accounting practice. While it does provide a more accurate picture of a business’s current condition, it is relatively complex and more expensive to implement than the cash accounting method.
Companies that use accrual accounting sell on credit, so projects that provide revenue streams over a long period of time affect the company’s financial condition at the point of transaction. It makes sense to use accrual accounting so that these events can be reflected in the financial statements during the same reporting period that these transactions occur.
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What Is the Accrual Method of Accounting?
Accrual Method of accounting reports revenues on the income statement when they are earned even if the customer might pay 30 days later.
At the time of a transaction, revenues are earned by the company will credit a revenue account and will debit the asset account of Accounts Receivable. The company will debit Cash and credit Accounts Receivable when the customer pays 30 days after the revenues were earned.
This method of accounting required that expenses and losses be reported on the income statement when they occur, even if payment occurs 30 days later.
For example, if a company has a repair done for $10,000 on August 15 and the vendor allows for payment on September 15. The company will report a repair expense and a liability of $10,000 as of August 15 and on September 15, the company will credit cash and debit the liability account.
Accrual method and associated adjusting entries results in a more complete and accurate reporting of a business’s assets, liabilities, equity and earnings for each accounting period.
What Is the Difference Between Cash and Accrual Method of Accounting?
Accrual and cash accounting are two opposites methods to record accounting transactions.
In cash accounting, transactions are recognized only when there is cash exchanged.
For example, let’s say a client requests a service on April 30th but does not make a cash payment until May 30th. With cash accounting, the revenue generated for the service will not be recognized until cash is received on May 30th.
Accrual basis accounting recognizes revenue when the service is provided for the customer even though cash isn’t yet in the bank yet.
The core underlying difference between accrual and cash accounting is the timing of recording the transaction. Over time, the results of the two methods should be about the same.
In conclusion, cash basis accounting records revenue when cash is received from a customer and expenses are recorded when cash is paid to suppliers and employees. Accrual basis accounting records revenue when earned and expenses are recorded when consumed.
What Is an Example of an Accrual?
Accruals are revenues and expenses, which a company has not recorded on their balance sheet but have an impact on the company’s income and assets that are based on accrual accounting, such as accounts receivable, accounts payable and interest expenses.
Accrual accounting recognizes adjustment of revenues that are realized by the delivery of a product or service. When cash is received the revenue needs to recorded and recognized on a balance sheet. It also recognizes expenses related to recognized revenue. Entries in the financial statement should match these accrued revenues and expenses.
For example, an employee bonus in an expense for a company. If the bonus is earned in the first quarter and not paid until the fourth quarter, this is an accrued expense for the business. Next year’s financial statements should record the bonus as an expense.
A common example of accruals is utility bills.
For example, a company has a manufacturing facility and uses water and electricity from the utility companies. The utility companies send their invoices on a billing cycle, which runs from the 20th of the current month to the 19th of the following month. So, the company receives the current utility bills on the 23rd of the following month and not before.
At the beginning of each month, let’s say, March, the company’s accountant closes the previous month, i.e. February. Because the utility companies do not bill their customers for the current month but for the next month, the accountant pays the utility bills of February in March and of March in April and so on. The company’s accountant has to adjust the entries in the financial statement so that the payments of the bills are reported as accrued expenses.