Readers will likely agree that understanding accounting methods is important for managing finances.
This article explains a fundamental concept - the accrual basis of accounting - in plain language, providing clear examples and an analysis of its advantages.
You'll learn the accrual accounting process, see how it differs from cash basis, understand key concepts like revenue recognition and expense matching, and evaluate whether switching to accrual basis could benefit your business.
Introduction to Accrual Basis Accounting
The accrual basis of accounting is an accounting method that measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur. Under the accrual basis, revenues are recorded when earned and expenses are recorded when incurred. This differs from the cash basis of accounting, which recognizes revenues and expenses only when cash is received or paid out.
The accrual basis allows for a more accurate financial picture of a business because it matches revenues with the expenses incurred to generate those revenues. This is in alignment with the gaap-generally-accepted-accounting-principles/">generally accepted accounting principles (GAAP) followed in the US. Key reasons why the accrual method is preferred for financial reporting include:
Understanding Accrual Basis of Accounting
The accrual basis of accounting:
- Recognizes revenues when they are earned, not necessarily when cash is received
- Recognizes expenses when they are incurred, not necessarily when cash is paid out
- Adheres to the revenue recognition and matching principles in GAAP
- Provides a more accurate picture of a company's profitability in a given period
For example, a consultation firm may provide services to a client in one quarter but may not issue an invoice and receive payment until the next quarter. Under the accrual basis, the revenue would be recognized in the quarter when the services were delivered.
The accrual basis is required for larger corporations and entities in the US and is considered the standard for financial reporting. However, smaller businesses may use the cash basis for internal purposes and tax reporting.
Accrual Basis Accounting with Examples
Here are some examples of accrual accounting in practice:
- Accounts Receivable: Revenue is recognized when a product or service is delivered, even if cash is not received until later. The expected cash inflow is represented by an asset called accounts receivable.
- Accounts Payable: Expenses are recognized when materials or services are received, even if cash payment has not yet been made. The expected cash outflow is represented by a liability called accounts payable.
- Unearned Revenue: Cash may be received in advance before a product/service is delivered. The business has an obligation to deliver the product or service in the future, thus the cash receipt is considered a liability called unearned revenue.
The percentage of completion method is an accrual method used for long-term projects to recognize revenue in line with the progress towards completion, rather than at project completion.
Accrual vs. Cash Basis: A Comparative Analysis
| Basis | Revenue Recognition | Expense Recognition | Financial Statements |
|---|---|---|---|
| Accrual | Upon delivery of product/service | When incurred | More accurate; matches revenues to expenses |
| Cash | Upon receipt of cash | Upon cash payment | Less accurate; timing gaps |
The accrual basis is required under GAAP because it provides a better indication of profitability and financial position. However, the cash basis may be easier to implement for small businesses and aligns with tax reporting requirements in many countries.
Ultimately, the choice depends on the size of the business, accounting needs, and reporting requirements. Larger businesses should use accrual accounting for financial statements and can use cash basis internally for decision making if required.
The Role of Accruals in Accounting
Accruals play an important role in the application of the accrual principle to recognize economic events in the appropriate period. These adjustments are made through journal entries that recognize revenues and expenses in the period they occurred, regardless of cash transactions.
Some examples of common accruals include:
- Prepaid expenses - Cash paid in advance for future expenses
- Accrued expenses - Expenses incurred but not yet paid in cash
- Accrued revenues - Revenues earned but cash not yet received
These accruals help account for all revenues earned and expenses incurred in the period, presenting a comprehensive and accurate financial picture. They are later reversed when the actual cash transaction occurs.
What is an example of an accrual basis?
For example, if a company provides a service to a customer in December, but does not receive payment until January of the following year, the revenue from that service would be recorded as an accrual in December, when it was earned.
Here is a more detailed example:
- In December, Company A provides $5,000 worth of consulting services to Client B.
- Company A delivers the work and invoices Client B for $5,000.
- Under the accrual basis of accounting, Company A records the $5,000 as revenue in December - the month when the services were provided/earned.
- In January of the following year, Client B pays the $5,000 invoice.
Even though Company A did not receive cash for the services until January, the revenue is recorded in the period it was earned (December) rather than when payment was received. This better matches revenues with expenses during each period.
Other key aspects of the accrual basis:
- Expenses are recorded when incurred, not necessarily when paid
- Revenues are recorded when earned, not necessarily when cash is received
- Provides a better picture of a company's performance during a period
So in summary, the accrual basis of accounting requires transactions to be accounted for in the period they occur, regardless of whether cash has been exchanged. This adheres to the revenue recognition and matching principles in accounting.
What is the accrual basis accounting process?
The accrual basis of accounting records revenues when they are earned and expenses when they are incurred, regardless of when cash is exchanged. Here are the key steps in the accrual accounting process:
1. Identify Business Transactions
Review all business transactions, such as sales, purchases of inventory or supplies, operating expenses, etc. Determine when revenues were earned or expenses were incurred, not just when cash changed hands.
2. Record Transactions in Journal
Record each transaction in the general journal, noting the date, accounts impacted, amounts, and whether it increases or decreases the account balance.
3. Post to General Ledger
Post the journal entries to the general ledger, which updates account balances on the balance sheet and income statement.
4. Adjust Entries
Record adjusting entries for accruals like unearned revenue, prepaid expenses, and depreciation to match revenues and expenses to the period in which they occurred.
5. Prepare Financial Statements
Use updated account balances to prepare financial statements, including the income statement and balance sheet, which reflect business performance.
6. Close Books
Make closing entries to transfer net income from temporary accounts to retained earnings, and reset revenue and expense accounts to zero.
Following the accrual basis ensures revenues are matched to expenses in the period in which they occurred, providing an accurate financial picture per GAAP standards. It prevents cash flow timing from distorting financial statements.
What is difference between cash basis and accrual basis?
The main difference between cash basis and accrual basis accounting is the timing of when revenue and expenses are recorded.
Cash Basis Accounting
With cash basis accounting:
- Revenue is recorded when cash is received from customers
- Expenses are recorded when cash is paid out
Cash basis is easier to implement but does not always match revenue and expenses to the time period in which they occurred. This can make financial reporting less accurate.
Accrual Basis Accounting
With accrual basis accounting:
- Revenue is recorded when it is earned, regardless of when cash is received
- Expenses are recorded when they are incurred, regardless of when cash is paid
Key aspects of accrual accounting:
- Revenue is accounted for when it is earned, even if cash has not yet been received
- Expenses are matched to the time period in which they helped generate revenue, even if cash has not yet been paid
- Provides a more accurate picture of a company's financial position
Accrual accounting is more complex but gives financial statements that better reflect the company's actual economic activity during each period. This is why accrual basis is required under Generally Accepted Accounting Principles (GAAP) for larger businesses and organizations.
In summary, cash basis is easier to implement but can distort financial reporting, while accrual better matches revenue and expenses to time periods but is more complex.
Is accrual basis accounting better?
Accrual basis accounting is generally considered better for most businesses because it provides a more accurate picture of a company's financial performance. Here's a quick overview of some of the key benefits:
More Accurate Financial Reporting
- Revenues are recorded when they are earned, not when cash is received. This better matches revenues with expenses incurred to generate those revenues.
- Expenses are recorded when incurred, not when paid. This prevents artificial spikes and dips in financial reports.
Better Visibility Into Cash Flow
- By recognizing revenues when earned and expenses when incurred, accrual accounting helps businesses better plan for future cash flow needs.
Adherence to Accounting Standards
- Accrual accounting complies with generally accepted accounting principles (GAAP) and IRS guidelines for recording economic events. This is required for audited financial statements.
However, accrual basis accounting also comes with more administrative work, since you are tracking two events for each transaction - when it is earned and when cash changes hands. So for very small or simple businesses like contractors, cash basis may be easier to manage. But as a business grows, accrual is usually the better choice for accuracy and reporting.
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Fundamentals of Accrual Accounting
Accrual basis accounting is a method of accounting where revenues and expenses are recorded when they are earned, regardless of when the money is actually received or paid. This differs from cash basis accounting, where revenues and expenses are recorded when cash is actually exchanged.
There are a few key principles that underpin accrual accounting:
Revenue Recognition on Accrual Basis
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Revenues are recorded when they are earned, not necessarily when cash is received. For example, a consultation fee would be recorded at the time the consultation services are delivered, even if the client hasn't paid yet.
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The percentage of completion method is commonly used for long-term projects to recognize revenues over time. Revenues are recorded in proportion to the percentage of work completed, rather than all at once when the project finishes.
Expense Recognition and the Matching Principle
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Expenses are recorded when obligations are incurred, regardless of when cash payments are made. For example, electricity expenses for the month would be recorded even if the bill hasn't yet arrived.
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The matching principle associates expenses to the revenues they helped generate, so they are recorded in the same reporting period. This gives a more accurate picture of profitability over time.
Adjusting Entries: Realizing Revenues and Expenses
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Adjusting journal entries are made at the end of accounting periods to account for unsettled revenues and expenses. These entries update the books prior to financial reporting.
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Common examples include: recording accrued revenues for services delivered but not yet billed, accrued expenses for bills not yet received, prepayments to account for expenses paid early, and depreciation to allocate asset costs over time.
Depreciation Expense: Accrual Accounting Treatment
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Depreciation allocates the cost of fixed assets like machinery and equipment over the useful life of the asset. A portion of the cost is expensed each year.
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Recording depreciation impacts the balance sheet by decreasing fixed asset amounts, and impacts the income statement with the depreciation expense each year.
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Depreciation continues even if the fixed asset is fully paid for, ensuring the matching principle is upheld over the full useful lifespan of the asset.
In summary, the key focus of accrual accounting is recognizing economic events as they occur, not based on cash transactions. This adheres to principles like revenue recognition and the matching concept to produce financial statements that better reflect true profitability. Adjusting entries and depreciation help account for unsettled items so accrual-based reports present a reliable view of financial position.
GAAP and Accrual Accounting
Generally Accepted Accounting Principles (GAAP) require companies to use the accrual basis of accounting. This ensures financial statements accurately reflect business performance and position.
GAAP Compliance: The Accrual Basis Requirement
The Financial Accounting Standards Board (FASB) establishes GAAP standards in the United States. Under GAAP, companies must use the accrual basis of accounting. This means:
- Revenues are recorded when earned, not when cash is received
- Expenses are recorded when incurred, not when paid
The accrual basis provides a more accurate picture of financial position than cash basis accounting. It matches revenues with related expenses per the matching principle.
The Impact of GAAP on Financial Statements
Adhering to GAAP and accrual accounting affects financial statements:
- The income statement reports revenues when earned and expenses when incurred during a period. This shows true profitability.
- The balance sheet reflects all assets, liabilities, and equity at a point in time under accrual accounting. This shows the real financial position.
- The cash flow statement shows the actual cash inflows and outflows.
Together, these statements provide clarity into financial performance and health.
Modified Accrual vs. Modified Cash Basis
Some companies can use a modified approach:
- Modified accrual recognizes revenues when cash is received and expenses when incurred.
- Modified cash basis recognizes revenues when earned and expenses when cash is paid.
But neither are acceptable under GAAP. Companies required to follow GAAP must use full accrual accounting.
Practical Applications of Accrual Accounting
Accrual accounting has several important practical applications in business scenarios. It provides a more accurate picture of a company's finances than cash accounting and is required for GAAP compliance.
Managing Accounts Receivable and Payable
When using accrual accounting, companies need to carefully track accounts receivable and accounts payable. This involves:
- Recording revenue when it is earned, not when payment is received
- Recording expenses when they are incurred, not when they are paid
- Using accounting software to generate aging reports on AR and AP
- Following up on overdue invoices and payments
Proper management of AR and AP is crucial for cash flow monitoring and projections.
Accounting for Cost of Goods Sold
Under accrual accounting, cost of goods sold (COGS) must be recognized in the same period as the revenue from inventory sales. Steps include:
- Tracking inventory costs including purchase prices and freight
- Assigning costs to units sold based on allocation methods
- Recording COGS expense when inventory sale revenue is earned
Accurately accounting for COGS also ensures proper reporting of gross profit and net income.
Corporate Finance Decisions and Accrual Accounting
Key corporate finance decisions depend on financial reports prepared under accrual accounting:
- Cash flow analysis - Provides better visibility into cash inflows/outflows
- Budgeting - More predictable projection of future earnings
- Investments - Assess return on capital and payback periods accurately
Adhering to accrual basis allows financially sound, data-driven business planning.
Tax Implications: Accrual vs. Cash Basis
The IRS permits both accrual and cash basis for tax reporting purposes. However, accrual better matches revenue and expenses to tax years in which business activity occurred. Under the Tax Cuts and Jobs Act, certain accrual methods may achieve larger deductions. Consultation with a tax professional is recommended when considering switching from cash to accrual accounting.
Transitioning to Accrual Accounting
Switching from cash basis to accrual basis accounting can provide more accurate financial reporting, but involves careful planning. Here is guidance for making this transition successfully:
Evaluating the Need to Switch
Deciding if switching accounting methods makes sense depends on several factors:
- Company size - Accrual accounting is required for public companies and commonly used by mid-sized and larger businesses. Smaller companies can often stay cash basis.
- Industry - Accrual is standard in many industries like manufacturing and SaaS. Others like professional services commonly use cash basis.
- Financial complexity - Companies with inventory, accounts receivable/payable, deferred revenue etc. benefit more from accrual accounting.
Conduct a cost-benefit analysis. Accrual better reflects financial position but requires more complex reporting.
The Process of Transitioning Accounting Methods
Follow these key steps to change from cash to accrual accounting:
- Review existing policies and procedures - Determine what needs to change in how transactions are recorded and reported
- Set a transition date - Pick a logical point to switch, like the start of a new month or fiscal year
- Adjust accounting software - Make necessary updates to record transactions on an accrual basis
- Reforecast financials - Project how accrual-based reporting will impact revenue recognition, expenses, etc.
- Retrain staff - Ensure all teams like sales, finance, execs understand implications of the change
Allow plenty of time and test accrual reporting before going live.
Projecting Financial Statements Post-Transition
When projecting future financial statements under accrual accounting:
- Revenue - Recognize at time of sale, not customer payment. Adjust unearned revenue balances.
- Expenses - Match expenses to related revenue as incurred, not when paid. Accrue liabilities.
- Balance sheet - Shift from only cash to recording accounts receivable/payable, deferred taxes etc.
Build detailed models for income statement and balance sheet line items under both prior cash basis and future accrual accounting for comparisons.
Carefully project and validate impacts before committing to this accounting change.
Conclusion: Embracing the Accrual Basis of Accounting
Recap of Accrual Accounting Essentials
The accrual basis of accounting is a fundamental concept in financial reporting, required for adherence to Generally Accepted Accounting Principles (GAAP). Key points:
- Revenues and expenses are recorded when earned or incurred, not necessarily when cash is received or paid out. This better matches revenues with expenses to determine true profitability.
- Assets and liabilities are also recorded as they are acquired or incurred based on contractual terms, providing a more accurate financial position.
- The accrual basis gives a better, more realistic view of financial performance than cash basis accounting. It includes non-cash items like accounts receivable and accounts payable.
Accrual accounting is indispensable for accurate financial statements. It prevents revenues and expenses from being skewed by timing of cash flows. This helps businesses better understand their profitability and make sound decisions.
Final Thoughts on Accrual Accounting and GAAP
Adoption of the accrual basis is necessary for adherence to GAAP standards mandated for many businesses. It provides transparency and accuracy in financial reporting.
The matching of revenues with expenses in the period they are incurred gives key insights for financial analysis. Accrual accounting ultimately leads to better business forecasting, budgeting, and strategy decisions.
While transitioning from cash basis may involve some upfront effort, the long-term benefits make embracing accrual accounting essential for sustainable success and GAAP compliance.
