What is Accrual Accounting?
Accrual accounting is an accounting method which records revenues and expenses when they are earned or incurred, regardless of when the money is actually transferred. This is in contrast to the cash basis of accounting, which records income only when the money is received, and expenses only when the money is paid out. Accrual accounting is one of the two primary methods of accounting, and is the most commonly used method in the world.
Under accrual accounting, businesses record revenues and expenses when they have an economic effect. Revenues are recorded when the goods or services are delivered, and expenses are recorded when goods are received or services are performed. This is irrespective of when the money for these goods or services is actually received or paid out.
Let’s look at an example. Assume that ABC Corp. is a manufacturing company. ABC has sold 1,000 widgets to a customer on January 1. The customer has agreed to pay within 30 days. Under accrual accounting, ABC will record the sale of the widgets on January 1, because that is when the goods were delivered. The customer will not actually pay until January 31, but under the accrual method, ABC records the sale when goods are delivered, not when payment is received.
Likewise, assume that ABC purchased 1,000 widgets on January 1 as well. Under accrual accounting, ABC would record the expense when the widgets were received. Again, this is regardless of when the payment is actually made.
The advantages of the accrual method of accounting are that it provides an accurate and comprehensive snapshot of the financial health of the business. All revenues and expenses are recorded, giving an accurate view of the liquidity of the business. This is advantageous to businesses as it allows them to be aware of their cash position at any given moment in time.
The downsides are that it can be more complicated, and requires a better understanding of financial statements. In addition, it does not provide as accurate of a view of the cash position, as some revenues and expenses are not matched with a cash transaction.
Overall, accrual accounting is a more complicated, but more accurate method of accounting. It provides a better overall view of the financial health of the business, and allows for better decision making. For businesses of any size, accrual accounting is the best way to account for their finances.
