Definition
Accrual accounting, also known as the accrual basis of accounting, is a method of accounting for transactions in which revenues and expenses are recognized when they are earned or incurred, rather than when cash is exchanged. Revenues and expenses are recognized in the same accounting period in which they are earned or incurred, regardless of whether money has changed hands. This approach is generally considered more informative and reliable than cash basis accounting, which recognizes transactions only when cash changes hands.
Accrual basis accounting therefore provides a more precise picture of how a business is performing by accurately matching revenues and expenses to their respective accounting period. This helps provide a more accurate view of a businesss underlying performance and resources, such as inventory.
History
Accrual accounting is believed to have been used since at least the fifteenth century and has long been the basis of financial reporting used by companies. In the United States, the Financial Accounting Standards Board (FASB) is the organization responsible for setting generally accepted accounting principles (GAAP) that govern financial statements. Under the current GAAP, all U.S. companies must use accrual basis accounting for financial statements such as the balance sheet and income statement.
Principle & Foundation
The accrual basis of accounting is based on the matching principle. This principle states that the accrual basis of accounting recognizes revenues when they are earned and expenses when they are incurred. This matches revenues and expenses to their respective accounting period, thus providing an accurate view of a companys financial performance for a given period.
For example, a company that recognizes revenue as it is earned will record sales for a particular period even if it has not received payment for those sales. Likewise, a company that recognizes expenses as they are incurred will record expenses for a particular period even if they are not yet due to be paid.
In addition to the matching principle, the accrual basis of accounting is based on two other accounting principles: realization and objectivity. The realization principle states that revenue should be recognized when it is realized or “real” (i.e. when money has changed hands). The objectivity principle states that the amount of the transaction should be reasonable and measurable.
Advantages
The main advantage of the accrual basis of accounting is that it provides a more accurate picture of a companys performance by capturing all relevant financial information related to a given accounting period. This includes all revenues earned, expenses incurred, assets purchased, liabilities incurred, and other economic activity occurring during the period.
In comparison, the cash basis of accounting can be less reliable, since it may not capture all of the financial transactions related to a given period. For example, a company that uses the cash basis method would only record a sale when the cash is received, even though the sale may have been made earlier in the period.
Disadvantages
The main disadvantage of the accrual basis of accounting is that it requires more detailed and complex accounting entries. This can be particularly challenging for small businesses that may lack the resources (e.g. accounting personnel) needed to maintain accurate and timely accounting records.
In addition, the accrual basis of accounting can make it difficult for management to quickly assess and respond to changes in a companys financial performance. This is because accrual basis accounting presents a future-oriented view of a companys performance, which may be difficult to interpret and respond to in a timely manner.
Example
To illustrate the accrual basis of accounting, consider a company that earns sales revenue of $20,000 in April. Under the accrual basis of accounting, the company would record the $20,000 in revenue in the April accounting period even if the cash payment was not received until May or a later period. Similarly, if the company incurred expenses of $15,000 in April, those expenses would be recorded in the April accounting period, even if the payment was not due until a later period. The company would therefore record a net income of $5,000 in the April accounting period, which may or may not match the actual cash flows for the period.
Conclusion
Accrual basis accounting is a method of accounting for transactions in which revenue and expenses are recognized when they are earned or incurred, regardless of when cash is exchanged. This approach provides a more accurate and meaningful picture of a companys financial position and performance by recognizing all relevant revenues and expenses. While the accrual basis of accounting is generally considered more reliable than other accounting methods, it can also be more time consuming and difficult to interpret for management.
