What is Accrual Accounting?
Definition: Accrual accounting is defined as an accounting method in which revenues or expenses are recorded at the same time when a transaction takes place instead of when the payment is made or received.
Accrual accounting is an accounting method where the revenue or expenses are recorded when the transaction occurs irrespective of the date of the payment made or received. This method of accounting follows the matching principle. In the matching principle of accounting, the revenues or payments should be recognized in the same period to match the balance sheet records.
In accrual basis accounting, receivables or payables can be recorded even if there is an absence of associated cash payment, cash receipt, or invoice. Cash and accrual are two accounting methods in which the cash method records transactions when payment occurs while the accrual method measures a company’s efficacy by recognizing economic events regardless of when the payment occurs.
In accounting, there are two methods of recording the transactions. The first is cash accounting, and the second is accrual accounting. In the cash accounting method, the transactions are recorded in the books of accounts only when the payment is made. But in the accrual accounting method, the transactions are recorded at the time of occurrence.
The basic concept of accrual accounting is that the economic events must be recognized when the transaction occurs rather than recording them at the time of payment. This method of accounting gives a more accurate picture of the company’s current financial position as it records the current cash inflows or outflows and the expected future cash inflows and outflows.
The FASB (Financial Accounting Standards Boards) has set out GAAP which is Generally Accepted Accounting Principles in the U.S. to dictate when and how companies are supposed to accrue for certain things for instance “Accounting for Compensated Absences” asks the employers to accrue a liability for future vacation days for their staffs.
Accrual Basis Accounting Categories
In accounting, the concept of accrual can fall under either revenues or expenses. Revenues and Expenses
1. Accrued Revenues
Accrued revenues are the income or assets that are incurred but not yet received. In the case of accrued revenues, a company may have delivered the goods on credit.
Example of Accrued Revenues
The best example of accrued revenue can be electricity consumption. The electricity company provides the utility to the consumers before receiving the payment for it. A consumer uses the electricity for a period, and then the company takes the record of consumption from the meter, which already counts the reading.
After the end of a specified period, the consumer is billed. Here, the electricity company pays its employees and all the variable or overhead cost incurred during that specified period.
Therefore, the accrual accounting method is more suitable for an electricity company to know its financial position. Here, the company will receive the payment from its customers at the end of the specified period, and the receivables will go down.
2. Accrued Expenses
Accrued expenses are those expenses that are incurred but not yet paid by the company. This can be when a company purchases raw material on credit. It includes interest expense accrual, suppliers’ accruals, or wage or salary accruals.
Example of Accrued Expenses
Suppose a start-up company has an employee under a cliff vesting plan and who is also going to receive an incentive after five years of commitment. Now, suppose the employee makes it through the first year with the help of hard work and qualifies for bonuses for five subsequent years. B
ut the company is not paying the bonuses to the employee materially. Here, the bonuses of the employees are accrued but not yet paid by the company. It is still a liability for the company. When the company pays the bonuses, this liability will go down.
Accrual Accounting Impact
- Accrual accounting adds another layer of accounting information to the existing information. It changes how an accountant records the transaction.
- This method helps in demystifying the accounting ambiguity that is related to liabilities or assets. This results in better anticipation of the revenues while keeping future liabilities in consideration.
- It helps the accountants to identify and monitor the potential cash flow or probability problem. They can also determine and find an adequate remedy for these problems.
How to Record the Accrual Transactions?
For recording the accrual transactions, the accountants need to use the accrual method of accounting. This accrual method of accounting allows the accountants to enter, adjust and track the unrecorded earned revenues and incurred expenses.
The journals will be adjusted on this basis to provide systematic and accurate information. The accrued expenses will be treated as liabilities, while the accrued revenues will be treated as assets. The closing balances of these two accounts will be reflected in the balance sheet as well.
Difference between Cash Basis Accounting and Accrual Basis of Accounting
In cash accounting, all the transactions are received when the cash is received or paid. The main advantage of using cash accounting is that it is simple. It only records the cash paid or receive, which records the better position of the cash in a company.
Tracking the cash flows with this accounting method is much easier. On the other side, the disadvantage of this method is that it overstates the health of the company. A company may have large sums of accounts payable, which get overlooked with this method.
Compared to cash accounting, the advantage of accrual accounting is that it includes all the accounts receivable and payables, which results in an accurate picture of profitability.
But the disadvantage of the accrual method is that it does not track the cash flow, which can overlook the condition of a company when they are a cash shortage in the short term. This method can also be more complex than the cost accounting method.
Problems with the Accrual Accounting
A key problem with accrual accounting can be a situation when an accountant indicates the presence of profits but the associated payment is not received yet that ultimately can result- a supposedly profitable business starving for cash and going into bankruptcy.
On the concluding note, it is clear that what accrual accounting is and how it works. It is considered the standard approach for recording financial transactions of all larger businesses.
Now, what will be your definition of accrual accounting?
Also how effective do you find accrual accounting in managing financial transactions?