What Is Accrual Accounting?
Accrual Accounting is one of the ways you can record transactions in your business. It’s an accounting method where revenue or expenses are recorded when a specific transaction occurs rather than when payment is received or made. The basic concept is that you record every time a customer pays you with a credit or debit card but do not account for any services you receive from them.
Today, companies use accrual accounting to track their investment in equipment, inventory, workforce, and other tangible assets. In addition, governments worldwide have validated this accounting method as more effective than the cash method. As a result, small businesses, partnerships, and sole proprietors often use it to allocate expenses more accurately.
How Accrual Accounting Works?
Accrual accounting recognizes revenue or expense when a contract is fulfilled; it occurs after an event has taken place. This allows a company to record its income and expenses more accurately over time while still keeping track of payments made.
The main advantages of this accounting method are simplicity and speed. In addition, accrual accounting is the most commonly used method by businesses for recording transactions. Transactions can be automatically tracked, such as a restaurant’s sales from one day to the next. This can help restaurants increase their monthly profits by keeping track of their order status from start to finish.
Most companies use some amount of this method even when they are fully paid in cash. This allows companies to account for any money on which judgment has been entered, but payments have not been received or must be made at some indefinite future time.
Accrual accounting helps businesses make more accurate financial decisions by providing a clear picture of the company’s financial condition at any given time. Accrual-based accounting recognizes revenue after the point of sale and before cash has changed hands. Additionally, accrual accounting considers costs as they are incurred rather than when the bill is due. Finally, accrual-based accounting includes expenses and revenues in the same accounting period, even though cash may not have been exchanged.
Accrual Accounting vs. Cash Accounting
Cash and accrual accounting are the two methods for tracking expenses that businesses use to expense their income.
As the business grows, the cash flow will increase. There are times when this increase in cash flow puts strain on the cash accounting system. If your company has highly variable cash flows, the accrual accounting method is the way to go. If your company has predictable cash flows and normal working capital requirements, then the cash accounting method is the way to go
Cash accounting uses a reliable record of cash flows to report the volume of products sold over time. In contrast, accrual accounting uses an up-to-date snapshot of a current period’s cash transactions to calculate the profit a business generates from sales or services consumed at that time.
Simply put, accrual accounting is a way for businesses to accurately report their income and expenses over time instead of every time a customer pays them. This helps companies reduce quarterly reporting requirements and increases accuracy and certainty in their financial statements.
Categories in Accrual Accounting
There are 2 main categories of Accrual Accounting
1. Accrued Revenue – Accrued revenues is an accounting term that means that an expense has been incurred, but the payment is not yet to be received by the company. This could be a purchase or a capital transfer from the previous owner to the current owner. Accrued revenues are growing rapidly, and it is causing quite a stir in the accounting world. It’s often used by startups, small companies, and older companies when creating budgets for growth or profitability.
2. Accrued Expense – Accrued expenses are money that comes due and is recorded with the balance sheet when a company makes credit purchases on its customers’ behalf. Generally, these funds are included in the company’s liability for unpaid debts that exceed credit limits, but they do not become part of its cash flow until the debt is paid off. Therefore, accruing expenses serve as cash outlays that must be financed through borrowings to stay alive, with some exceptions.
Components of Accrued Expenses include
- Interest expense accruals: Interest expense accruals are the expenses accrued but not yet paid.
- Suppliers accruals: Suppliers’ accruals represent accrued unpaid expenses for goods or services rendered by third parties. This account is usually found on a company’s balance sheet and is a liability account.
- Wage or salary accruals: Wage and salary amounts that are owed to employees. This amount is considered accrued because employees worked for part of the month without receiving their full earned monthly salary.
Impact of Accrual Accounting
In addition to providing additional recorded information, accrual accounting helps the financial records become more predictable. Better record keeping allows businesses to predict revenue more accurately while keeping track of future liabilities and other costs.
Accruals address uncertain revenue and uncollectible debt. They help accountants determine how much cash will be available in the future and whether any problems with debt levels can threaten the business.
The Relationship between Accrual Accounting and Cash Accounting
The accrual-based accounting and cash-based accounting methods are primarily different in the way transactions are represented. In accrual accounting, financial transactions are reported as they happen, and both credits and debits are considered. However, in cash-based accounting, profits are only recognized when there is a subsequent increase in cash.
Accruals are events or transactions whose accrual is probable even though the cash has not yet been received or paid. The accounting for such events or transactions depends upon an accounting theory known as the accrual method. This method enables the accountant to enter, adjust, and track unrecorded revenues and expenses. The accountant must follow a systematic procedure for adjusting journal entries to make the records usable in the financial statement reports. These adjustments must be verifiable.
Accrual Accounting vs. Cash Basis Accounting Example
Let’s assume you are in the business that supplies raw materials. If you sell $20,000 worth of raw material under the cash method, that amount is not recorded in the books till the customer pays you the money or gives you the check. Under the accrual method, the $20,000 is recorded as revenue as soon as the sale is made, irrespective of whether you receive the money a few days or weeks later.