Accounting Basics: What Is Accrual Accounting?

Accrual accounting is a method of accounting that tracks expenses and revenue as they are incurred. It's often the preferred method of accounting by companies and accountants, as it can provide a more accurate picture of a company's financial position than other methods of accounting.

Key takeaways:

• Accrual accounting is a widely adopted method that recognizes revenues and expenses when they are earned or incurred, providing businesses with an accurate financial picture.
• Core components of accrual accounting include accrued revenue, accrued expenses, and deferred revenue, which allow for reporting revenues and expenses in the appropriate periods.
• Accrual basis provides various benefits to businesses, such as enabling them to anticipate cash flow issues, track performance over time & monitor trends - all contributing to their growth & success.

How accrual accounting works

The accrual method recognizes a company's income and debts when a transaction happens rather than when a company receives a payment or pays an expense. This allows a business to take a longer-term view of its finances than simply checking its cash amount.

For instance, a company that charges an hourly fee for its services might bill its customers at the end of every month. Accrual is standard accounting practice that would let the company put the revenue from the hours it works on its books as they occur rather than having to wait for when the client pays.

Expenses work the same way. Any costs the company incurs but hasn't paid yet are recorded on its books as accrued expenses.

How does accrual accounting differ from cash accounting?

Businesses need to grasp the distinction between accrual accounting methods and cash-based accounting. The accrual method of accounting records transactions as they occur, regardless of when money changes hands. This method provides a more comprehensive and accurate financial overview of a company's financial statements, considering both earned revenues and incurred expenses. On the other hand, cash-based accounting only records transactions when cash is received or disbursed, which may not accurately represent a company's financial health.

An example of accrual accounting would be if the company recorded this income during the month the work was performed. Doing so follows the matching principle and makes determining a company's financial health easier.

Large businesses typically utilize accrual accounting when preparing their tax returns because it provides a detailed financial picture, facilitating better decision-making and planning. However, smaller businesses with simpler financial structures may opt for cash-based accounting, which may be easier to manage and maintain. Ultimately, the choice between the advantages of accrual accounting and cash-based accounting depends on the size, complexity, and business needs.

What is the matching principle in accounting?

The matching principle is an accounting concept that states expenses tied to revenue should be recorded during the accounting period they occur. It matches the money you spent to make money with the money you made.

The matching principle is at the heart of the accrual accounting principles. It allows businesses to generate accurate balance sheets without waiting for cash payments to change hands.

Key components of accrual accounting

At the core of the accounting practice of accrual accounting are three principal components: accrued revenue, accrued expenses, and deferred revenue. These components ensure that revenues and expenses are recognized and recorded in the appropriate time periods, adhering to the principle of matching expenses and revenues.

The following subsections will delve deeper into each component and explore their significance in accrual accounting.

Accrued revenue

Accrued revenue refers to income or assets that have been earned but not yet received. For instance, a utility company provides electricity to customers before receiving payment for the service. A business would debit an “accrued revenue" account to record accrued revenue. They would also credit a “sales" or “revenue" account. This ensures that the financial statements accurately reflect the company's revenues, even if the cash has not yet been received.

Accrued revenue is essential for businesses that offer subscription services, such as software companies. For example, a company offers a monthly subscription for $100, and by the end of January, they have provided the service but have not yet received payment from their 100 customers. By recording accrued revenue, the company can accurately track its income and match it with the corresponding expenses, providing a more precise portrayal of its financial performance.

Accrued expenses

Accrued expenses are the opposite of accrued revenues. They represent expenses incurred but not yet paid and are recorded as liabilities on the balance sheet. For example, a company may use electricity throughout January but only receive the bill at the end of March. The anticipated cost of electricity for January would be recorded as an accrued expense.

Recording an accrued expense involves debiting the “expense" account and crediting the cash account to the “accounts payable" account. This process increases expenses on the income statement. It creates a liability on the balance sheet, ensuring that the company's financial statements accurately reflect its obligations and expenses, even if the cash has not yet been paid.

Deferred revenue

Deferred revenue, also known as unearned revenue, is income received before the provision of goods or services and is recorded as a liability on the balance sheet until it is earned. This concept is crucial in industries such as software subscriptions, where payment is often received in advance. In such situations, companies recognize the revenue throughout the subscription period as they service the customers.

The act of recording deferred revenue enables businesses to:

• Keep an accurate track of their subscription income
• Match it with the corresponding expenses
• Ensure a precise reflection of the company's financial performance in their financial statements

This method follows the accrual accounting principle. According to this principle, revenue should be acknowledged once earned, independent of when payment is received.

Recording transactions in accrual accounting

Recording transactions in accrual accounting involves a systematic process of identifying revenues and expenses, creating journal entries, and updating financial statements. This method ensures that financial statements accurately reflect the company's financial position and performance, allowing businesses to make informed decisions based on their true financial health.

Let's examine the steps involved in recording transactions in accrual accounting.

Identifying revenues and expenses

Accurate identification of revenues and expenses is a key aspect of accrual accounting. This involves recognizing revenue when it is earned, regardless of when payment is received, and recognizing expenses when they are incurred, regardless of when payment is made. For example, a marketing company may earn revenue from a project in one month but receive payment in another month. By accurately identifying revenues and expenses, the company can ensure that its financial statements represent its financial position.

Examples of revenues earned but not yet paid include accrued interest, accrued rent, accrued fees, and accrued sales revenue. On the other hand, expenses incurred but not paid include purchases made on credit, salaries, and taxes. By first identifying these revenues and prepaid expenses, businesses can ensure that their financial statements accurately reflect their financial performance and provide a basis for informed decision-making.

Creating journal entries

Once revenues and expenses have been identified, the next step is to create journal entries for these transactions. In accrual accounting, double-entry accounting records transactions by debiting the same period and crediting the relevant accounts. For example, an adjusting entry would be created by debiting an accrued revenue account and crediting a revenue account to record accrued revenues.

Similarly, a journal entry would be created to record accrued expenses by debiting an expense account and crediting an accounts payable account. These accounting journal entries ensure that revenues and expenses are accurately recorded in the financial statements, providing a clear and comprehensive view of the company's financial position and performance.

What is double-entry accounting?

Most business transactions use two accounts under double-entry accounting principles. The first account is either accounts receivable or accounts payable. A company records this when it invoices a client or receives a bill from a third party.

The second account is when the payment is made. The company then adjusts its cash on hand based on whether it received cash payment or sent a payment.

Updating financial statements

Once journal entries for accrued revenues and expenses have been created, the subsequent step involves updating the financial statements to reflect these transactions. Revising the balance sheet and income statement to portray the company's financial position and performance accurately. Specifically:

• Accrued revenues are recorded as revenue on the income statement
• Accrued revenues are recorded as accounts receivable on the balance sheet
• These transactions impact the net income calculation.

On the other hand, accrued expenses increase expenses on the income statement and create a liability on the balance sheet, accurately reflecting the company's financial position. By updating the company's financial statements to include accrued revenues and expenses, businesses can ensure that their financial reports represent their financial health, allowing for informed decision-making and planning.

Benefits of accrual accounting for businesses

Businesses stand to gain various advantages from accrual accounting. Firstly, accrual and cash accounting provide a more accurate financial picture at any point in time, allowing businesses to manage their finances better and make informed decisions. Additionally, accrual accounting assists businesses in anticipating cash flow and profitability issues, ensuring they can plan and strategize effectively.

Beyond providing an accurate financial picture, accrual accounting also aids in decision-making by allowing businesses to:

• Track their performance over time
• Monitor trends
• Identify areas for improvement
• Adjust their strategies accordingly

This ultimately contributes to the growth and success of the business.

What is accrual accounting good for?

Accrual-based accounting generally provides a clearer picture of how a company is doing financially.

Cash-based accounting only provides a snapshot of how a company is doing at that point in time. It may not matter that a company has $100,000 in cash one month if it has a $200,000 expense due the next month with no expected income. Accrual accounting prevents situations like this from occurring.

Who should use accrual accounting?

Most businesses can benefit from using the accrual method of accounting.

Adopting accrual-based accounting methods is often a necessary step for businesses seeking outside funding. Banks or other lenders require companies to use the accrual accounting method for their financial records. This helps the lender determine whether loaning a business money is a safe or risky proposition.

How are accounts receivable tracked under accrual accounting?

Accounts receivable is the amount of money a company has billed its customers but not yet collected. It's how a business can track the income it has accrued on its financial statements. Once the money has been paid, the company deducts that amount from accounts receivable and lists it as part of its cash on hand.

An example of accounts receivable in action would be if a software company signed a new client for a $10,000 monthly subscription to its services. The software company invoices the client at the start of the month and adds $10,000 to its balance sheet under accounts receivable. At the end of the month, this $10,000 entry shifts to cash when the client pays its invoice.

How are accounts payable recorded using accrual accounting?

Accounts payable refer to charges a company has received but not yet paid. They're recorded and recognized like expenses are recorded as accounts receivable.

Say a company received a bill for $5,000 due at the end of the month. That $5,000 charge would first be recorded on the company's balance sheet under accounts payable. At the end of the month, the company would remove the $5,000 from the asset account under accounts payable and deduct that amount from its amount of cash.

When should I use cash-based accounting?

Adopting accrual accounting can benefit most but not all businesses. A few companies may be better off sticking with cash-based accounting.

Cash-basis accounting is simple. That makes it easy for sole proprietors who run small businesses to track their cash flow easily. It may be the right choice for companies that don't have many overhead expenses to track, aren't looking for outside investment, and don't have more than $26 million in annual gross receipts over three years.

Using cash-basis accounting does come with many tradeoffs. It's harder to determine a company's financial well-being as you can't see where the money is coming or going in the future.

Understand whether accrual accounting is right for you

The selection of an appropriate accounting method for your business. Factors to consider when choosing an accounting method include:

• The size, complexity, and stakeholder needs of your business
• The accuracy and timeliness of financial reporting required
• The level of detail and analysis needed for decision-making
• The industry standards and regulations that apply to your business

While accrual accounting is the preferred choice for most organizations due to its ability to provide a more accurate financial picture, some small businesses with simpler financial structures may opt for cash-based accounting.

Ultimately, the choice between accrual and cash-based accounting depends on your business's specific needs and circumstances. By carefully assessing your business's financial requirements and considering the advantages and disadvantages of each accounting method, you can select the approach that best suits your organization and fosters growth and success.

Summary

In conclusion, accrual accounting is a powerful tool for businesses to understand their financial position and performance better. By recognizing revenues and expenses when earned or incurred, accrual accounting provides a comprehensive and accurate financial picture that aids in decision-making and planning. Accrual accounting is an essential aspect of modern business management. Embrace the power of accrual accounting and unlock your business's true potential.

Frequently asked questions

What is accrual accounting in simple terms?

Accrual accounting is the process of recording transactions as they occur, regardless of when payment is received or made.

What is an example of accrual accounting?

An example of accrual accounting is when a company records revenue when it is earned, regardless of when the money is actually received. This includes recording sales of goods as revenue when they are shipped to customers, even if payment has not been received. Taxes incurred are also commonly accrual basis accounting as accrued expenses until they are paid.

What is the difference between cash and accrual accounting?

Cash-based accounting records revenue and expenses when actual payments are received or disbursed, while accrual accounting recognizes revenue when it's earned and expenses when they're incurred, regardless of when money changes hands. This is the main difference between cash accounting and accrual accounting.

What are the two types of accrual accounting?

The two main types of accrual accounting are revenue accruals and expense accruals. These represent services performed and expenses incurred but not received in cash or recorded. There may also be other specific accruals, such as accrued interest, salaries, and taxes.

Why is accrual accounting considered more accurate than cash basis accounting?

Accrual accounting provides a more accurate picture of a company's financials by recognizing revenues and expenses when they are earned or incurred, as opposed to cash basis accounting which only recognizes them when payment is received or made.