What is the Accrual Accounting Basis?
Accrual Accounting is the most accepted accounting principle which states that revenue is recognized when the sale is done (irrespective of the cash or credit sale) and the expense is matched and recognized along with the corresponding revenue (irrespective of whenever it’s paid).
Accruals in Accounting are the expenses or revenues that have been recorded by the firm but not yet realized. In simple terms, they are the financial transactions already estimated in the current accounting cycle and payment for which is done in the future.
The main reason for using this is to get a fair and accurate picture of the business at any given stage. Let’s say that you, an investor, want to know where a business stands at any given point in time. So what would you want to know? You would want to know how a business is doing right now, not what a business will receive shortly. If a company is using the accrual basis of accounting, then as an investor, you won’t be in doubt – whether the current affairs of the company are the most accurate or not.
It showcases exactly what is happening in the business, not what a business will achieve shortly. For example, if a firm has sold products on credit, then it will show the same as sales even if the money is yet to be received by the company.
Another vital point about is that it is applicable for businesses that are relatively medium to large and which earn a decent amount of cash flow during any year.
How Accrual Accounting Works?
Let’s look at a few practical accrual accounting examples.
Example#1 – Accounts Payables
Difference Ltd. has salaries payable of $40,000. How would we treat it as per the accrual basis of accounting?
The effect of this transaction would be two dimensional. That means one needs to record this transaction in two places.
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First, it would be recorded as salary expenses in the income statement. And then, it would be treated as a current liability and will be recorded on the balance sheet of the company.
Let us now look at a practical example. Below is the snapshot of Colgate’s Current Liabilities. We note that Colgate has reported accounts payables of $1,124 million in 2016 and $1,110 million in 2015. Accounts payables primarily consist of salary payables.
source: Colgate SEC Filings
Example#2 – Prepaid Expenses
Similar Ltd. has prepaid wages of $100,000. How would we treat it as per the accrual basis of accounting?
This transaction is the opposite of the previous example.
We will record the transaction in two places.
Below is the snapshot of the Facebook Balance Sheet. We note that Facebook has reported prepaid expenses of $959 million and $659 million in 2016 and 2015, respectively.
source: Facebook SEC Filings
Example#3 – Accounts Receivables
Equal Ltd. has total sales of $10, 00,000. Out of the total sales, 60% is in cash. How would we treat this transaction under accrual accounting?
Here, 40% of sales are credit sales. But the credit sales will also be treated as sales, and the profit would be generated by including both the cash and credit sales and then deducting the cost of goods sold and the operating expenses.
If it were cash accounting, we wouldn’t have recorded the credit sales.
Below is again an example from Colgate’s Balance Sheet. We note that Colgate has reported accounts receivables of $1,411 million on $1,427 million in 2016 and 2015, respectively.
source: Colgate SEC Filings
Consider an FMCG firm that sells products to the retail stores. These products are finished goods and can be sold to the consumers and are worth 25,000 $. Now the retailer does not make this payment upfront but promises to pay the amount in the next quarter. Let’s consider the table below, which summarizes the sequence of events.
Hence even though the amount was received on 1 Apr for the goods delivered on 1 Feb, such accruals will be recorded as accounts receivable on 1 Feb itself. On the other hand, in cash-based accounting, such revenues are accounted for or recorded only when the actual payment is received.
Let’s consider a practical example. Refer to the following screenshot depicting Amazon.com’s financials.
Here, one can observe that in the Accounts receivables section, the firm has recorded some numbers. These payments that the firm expects to receive from its customers for the services or the goods delivered. But since this payment is not yet received, there is a credit risk involved as there is an element of uncertainty, and that is why the firm has also recorded Bad debt or doubtful accounts. This is a good accounting practice and helps in removing the ambiguity of the accrual-based revenues.
- It is a holistic approach: Unlike cash accounting, accrual accounting is a comprehensive accounting system. You would agree that a business is not about cash only. There are many aspects that should be taken into account. Under the accrual system, we can record all the financial transactions of business (cash and others), and we can also create financial statements like the income statement, balance sheet to get a more holistic view of how a company is doing overall.
- There are almost no discrepancies/errors: Since the financial transaction is immediately recorded as it occurs, there are virtually no chances of discrepancies or inaccuracies. And since everything is recorded all the time, if one wants to do an audit, the information is readily available.
- Accuracy level is higher: Unlike cash accounting, accrual accounting follows a double-entry system. That means one account is debited and another account is credited. As a result, we can see how one account is reduced, and another account has increased. It increases the accuracy level of accounting, and later on, during an audit, things get easier.
- It is recognized by Companies Act: It is recognized by the Companies Act, and that’s why a vast number of companies follow this.
- Quite complex: Cash accounting is easy to record and easy to maintain. But accrual accounting is complicated to record since every time a financial transaction happens, there should be an entry in the books of accounts. And maintaining the whole accounting system isn’t an easy job as well.
- Holistic but challenging to maintain: A business has different aspects. And if a business is enormous, in the single day hundreds and thousands of financial transactions need to be recorded under this accounting. Maintaining all of these every day, day after day, isn’t an easy job for an accountant.
Accrual Accounting Basis Video
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