Accrual accounting is a prevalent accounting approach that offers a more precise and extensive representation of a firm's financial well-being. This type of accounting follows the matching principle by acknowledging revenue and expenses when they are generated or incurred, instead of when cash transactions occur, enabling businesses to gain a deeper insight into their financial performance. In this article, we will explain the accrual accounting term, the way it reflects in balance sheets, accruals benefits, and, finally, demonstrate some examples.
Accruals are an important aspect of financial accounting as they enable companies to record expenses or income that has been incurred, but has not yet been received or made. Accruals are based on the concept of matching expenses with revenue and are calculated by considering the expected future costs or revenues of a business. They are calculated by adding the expenses that have been incurred, but not yet paid, to the income that has been earned, but not yet received. Accruals are then reflected in the company’s financial statements as either a debit or a credit in the current period depending on whether it is an expense or an income. This type of accounting is important because it helps to create an accurate picture of a company’s financial position and statements used by stakeholders, investors, regulators or creditors.
A fundamental concept in accrual accounting is the matching principle, which states that revenues and expenses should be recognized in the same period they are earned or incurred. This principle ensures that financial statements provide a clear and accurate view of a company's profitability during a specific period. By matching revenues and expenses, businesses can more effectively monitor their financial performance and identify potential cash flow or profitability issues.
Accruals are represented in both the income statement and the balance sheet. On the income statement, accruals represent revenues earned or expenses incurred that impact a company's net income, even though cash related to the transaction has not yet changed hands. Accrued revenues or assets are income or assets that are yet to be received but have resulted from an economic transaction. These accrued revenues are recorded as receivables on the balance sheet.
For example, when accrued expenses are recognized, they are recorded as accounts payable under the current liabilities section of the balance sheet and as expenses in the income statement. When the bill is paid, the accounts payable account is debited, and the cash account is credited on the general ledger.
Accrued revenues and assets are recorded on the balance sheet, and they have an impact on the company's revenues and current assets. Conversely, when an accrual is created for an expense, it is typically recorded as an expense on the income statement and as an account payable on the balance sheet, under the current liabilities section.
Here are three major advantages:
1) Improved Financial Analysis: Accrual accounting provides a more accurate view of a company's financial status by recognizing revenue when it is earned and expenses when they are incurred, regardless of the timing of cash transactions. This allows businesses to better analyze their financial performance and make informed decisions.
2) Compliance with Generally Accepted Accounting Principles (GAAP): Accrual accounting is in line with GAAP, which are widely recognized accounting standards used for financial reporting. By adhering to GAAP, businesses can ensure that their financial statements are comparable and consistent with those of other companies.
3) Better Cash Flow Management: Accrual accounting helps businesses identify potential cash flow issues by recognizing revenue and expenses when they are earned or incurred, rather than when cash is exchanged. This allows businesses to monitor their cash flow more effectively and make adjustments as needed.
Let’s take a look at the list of life examples when accrual-based accounting may be used:
Example 1 - Sales on Credit:
A XXX tech company, has total monthly sales of $20,000. About 65% of these sales are in cash, while the rest is on credit. Using accrual accounting, the company records the credit sales as revenue as soon as it sends an invoice to a customer, regardless of when the payment is received.
Example 2 - Purchase on Credit:
Sport's World, a sporting goods store, receives $5,000 worth of soccer balls from the manufacturer Soccer Experts on March 1 and stocks them on its shelves in advance of the soccer season. The company buys the inventory on credit and records the expense when the inventory is received, not when the payment is made.
Example 3 - Income Tax Expenses:
If a company estimates that it owes $12,000 in income tax for the year, it would accrue $1,000 per month in income tax expenses, even if the actual payment is made at the end of the year.
Example 4 - Rent Paid in Advance:
Suppose John rents a house from Sam at $100,000 per year. John pays Sam $50,000 in January and another $50,000 in July. Using accrual accounting, John records rent expenses of $100,000 for the year, regardless of when the cash was paid.
Example 5 - Interest Received on Fixed Deposit (FD):
If a company has a fixed deposit that earns $1,200 in annual interest, it would accrue $100 per month as interest income, even if the interest is only paid at the end of the year.
Example 6 - Insurance Expenses:
A company pays an annual insurance premium of $12,000 in January. Using accrual accounting, the company records $1,000 per month as insurance expense, spreading the cost over the entire year.
Example 7 - Electricity Expenses:
A firm consumes $4,500 in utility (electricity) in June but remains unpaid on the balance day (June 31). The firm then receives its bill for the utility consumption on July 5 and makes the payment on July 25. Using accrual accounting, the company records the $4,500 as an electricity expense in June when the service was consumed, not when the payment was made.
To sum up, accrual accounting is a secure, accurate way to log business transactions and keep tabs on income and expenses. By adhering to the matching principle and recognizing revenues and expenses when they are earned or incurred, accrual accounting provides a more accurate and comprehensive view of a company's financial performance. While cash-basis accounting may be suitable for some small businesses or freelancers, accrual accounting is the preferred method for businesses seeking a true representation of their financial position and compliance with GAAP.
What are the differences between accrual accounting and cash accounting?
Accrual accounting documents financial transactions when they occur, whereas cash accounting records transactions solely upon the receipt or payment of cash. By accounting for outstanding revenues and expenses, accrual accounting offers a more precise depiction of a company's financial standing.
What are the strengths of accrual accounting?
Some advantages of accrual accounting include a more accurate representation of a company's financial health, improved financial planning and analysis, better matching of revenues and expenses, and increased transparency for stakeholders.
What are the drawbacks of accrual accounting?
Accrual accounting can be more complex and time-consuming than cash accounting, as it requires tracking receivables and payables. It may also result in temporary discrepancies between reported income and actual cash flow, potentially making it harder to assess short-term liquidity.
Is accrual accounting required for businesses?
Typically, small businesses and sole proprietorships have the option to select either cash or accrual accounting. Nevertheless, the majority of medium and large enterprises, along with those mandated to adhere to Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), are required to employ accrual accounting.
What are accounts receivable and accounts payable in accrual accounting?
Accounts receivable represent the money owed to a company by its customers for goods or services provided on credit. Accounts payable represent the money a company owes to its suppliers or vendors for goods or services received on credit. Both accounts are essential components of accrual accounting.
What is an accrual adjustment?
An accrual adjustment is a log entry made at the end of an accounting period to record revenues earned or expenses incurred but not yet recorded. Accrual adjustments ensure that a company's financial statements accurately reflect its financial position in accordance with the revenue recognition and expense matching principles.
How to convert from cash accounting to accrual accounting?
To convert from cash accounting to accrual accounting, you'll need to adjust your financial records to recognize outstanding revenues and expenses. This may involve adding accounts receivable and accounts payable to your balance sheet and making accrual adjustments for any unrecorded revenues and expenses. It is recommended to consult with an accountant or financial advisor to ensure a smooth transition.