The accrual basis of accounting is an important part of the recognition aspect of accounting, whereby every transaction is accounted for at the moment it occurs, irrespective of when the cash is exchanged. This ensures that the financial statements reflect the true position of the company at any given time, which is more accurate and comprehensive. Accrual accounting becomes important when companies enter into credit sales or purchases. This is the case since it allows companies to recognize revenues and expenses as they occur and provides a clearer view of the financial health of the company.
Most firms prefer accrual accounting since it is required in different accounting standards, including GAAP and IFRS. With this system, a business can be assured that revenues and expenses will be recognized in the period they are earned or incurred, making its records align with the economic realities of its operations.
What is Accrual Basis of Accounting?
Accrual accounting is an accounting method whereby revenues earned and expenses incurred within a period are brought in and recognized, irrespective of the fact that cash may not have been received or paid. It, therefore, differs from cash-based accounting since transactions are recognized based merely on the availability of cash.
Key Features:
- Revenue Recognition: Earned revenue is recorded when it is earned, irrespective of whether the cash is realized or not.
- Expense Recognition: Expenses are expensed as incurred, though not necessarily when cash outlays occur.
- Matching Principle: Expenses are matched to revenues during the same period to show the true profit of a business.
Larger businesses prefer accrual because it provides a true situation for the company. Accrual facilitates better matching of revenues and expenditures in the respective periods, allowing stakeholders to make appropriate decisions from the data about the finances.
How Accrual Accounting Works?
Accrual accounting operates based on two fundamental principles: revenue recognition and matching.
Revenue Recognition Principle
According to the revenue recognition principle, there has to be recognition and recording of an amount of revenue at the same time it is earned and not when that cash was realized. It can thus be seen that if a firm receives services in January but collects the payment in March the value of revenue is accumulated to reflect performance during the period when the service was rendered.
Matching Principle
The matching principle requires expenditures to be recognized during the same period in which revenues they are directly associated with are realized. This ensures that, in turn, an income statement provides the best possible reflection of the cost of revenues earned. For example, for the company that purchases material in February but sells the product in March, the material cost will be provided for in March for expensing the revenue from the sale.
Steps in Accrual Accounting:
- Identify all revenue and expense events that occurred during a particular period.
- Accrued revenues when earned, though not necessarily received in cash.
- Accrued expenses when incurred, though payment has not been made.
- Use accrual accounting to modify financial statements to show the real position – including accounts receivable and accounts payable.
Benefits of Accrual Accounting
Accrual accounting is particularly beneficial for the complex financial operations of a business.
Accrual accounting offers benefits, including the following that are extremely relevant for businesses whose financial activities are more complex.
- Better Financial Representation: Under accrual accounting, revenues and expenses are recognized at the point of earning or incurrence. This provides a better perception of a firm’s financial situation. Under cash-based accounting, such distortion may be present that large cash inflows or outflows in one period may distort results.
- Better reconciliation between revenues and expenses: The best way to explain it is through a matching principle; it ensures that revenues go along with the expenses that elicited those revenues in the same period, which gives a true reflection of profitability.
- Improved management of finances: Accrual accounting helps businesses in the management of finances because it aids businesses in tracking out liabilities, such as accounts payable and accounts receivable. It gives companies the ability to plan for future cash needs based on outstanding obligations.
- Compliance with Accounting Standards: An accounting standard, such as GAAP and IFRS, mandates that businesses obligated to adhere to those guidelines must keep their accounts on an accrual basis.
When to Use Accrual Basis Accounting
While accrual accounting gives a truer picture of the financial situation of a business, not all businesses lend themselves easily to accrual-based accounting. Businesses that are very small, like sole proprietorships and partnerships, opt for cash-based accounting because of its simplicity.
Accrual Accounting is Ideal for:
- Big Businesses: All those businesses whose transactions can be very complicated, especially if they involve long-term projects, or which have big accounts receivable or payable should adopt accrual accounting.
- Public Companies: All public firms must adopt accrual accounting to ensure them being in line with GAAP/IFRS
- Firms with Credit Sales: All firms whose sales transactions are performed through credit must utilize accrual accounting to ensure appropriate reflection of revenues and expenses.
Accrual Accounting is Less Suitable for:
- Small Businesses: Small businesses having fewer simple financial transactions and having fewer or no accounts payable or receivable may find it straightforward to adopt cash-based accounting.
- Cash-Heavy Businesses: Businesses that use a lot of cash transactions with the majority of dealings using cash may not find the need for accrual accounting and find it cumbersome.
Difference Between Cash Basis and Accrual Basis of Accounting
| Feature | Accrual Basis | Cash Basis |
|---|---|---|
| Revenue Recognition | Revenue is recorded when earned | Revenue is recorded when cash is received |
| Expense Recognition | Expenses are recorded when incurred | Expenses are recorded when cash is paid |
| Financial Picture | More accurate, matches revenues with expenses | May distort financial picture, as cash flows vary |
| Complexity | More complex, requires adjustments | Simple and straightforward |
| Regulation | Required by GAAP and IFRS | Optional for small businesses |
| Best Suited For | Large businesses, publicly traded companies | Small businesses, sole proprietorships |
Conclusion
Accrual basis of accounting is necessary for most businesses that need to have an all-around perspective of their financial situations. As this method recognizes revenues as well as expenses when they are earned or incurred, it is also aligned with economic reality in terms of the company’s activities. For a business, accrual accounting is managed and hence aligned with the best practices applied internationally through this accounting standard. It is thus preferred by most medium to large companies.
Accrual Basis of Accounting FAQs
What is the main difference between cash basis and accrual basis accounting?
The primary difference is that accrual basis accounting records transactions when they are earned or incurred, while cash basis accounting records them when cash is exchanged.
Why is accrual accounting preferred for larger businesses?
Accrual accounting is preferred because it provides a more accurate financial picture by matching revenues with expenses and keeping track of accounts receivable and payable.
Is accrual accounting required for all businesses?
No, it is required for publicly traded companies and businesses following GAAP or IFRS, but small businesses may opt for cash basis accounting.
Can small businesses use accrual accounting?
Yes, small businesses can use accrual accounting if it suits their financial needs, especially if they deal with credit sales or long-term projects.
What are the disadvantages of accrual accounting?
The main disadvantage is its complexity, as it requires more detailed record-keeping and frequent adjustments to ensure accuracy.
