What Is Accrual Accounting?
The Accrual Accounting principle states that revenue is recognized when the sale is completed,regardless of whether it is a cash or credit sale. Expenses are matched and recognized concurrently with the corresponding revenue irrespective of when the expense is paid. Businesses keep a tab on accruals to ensure the tracking of their receivables and payables.
Various types of accrual transactions can be found in the book of businesses but according to the accrual accounting basics, they fall under either expense accruals or revenue accruals. Accounting on an accrual basis gives an apt financial overview of the company and provides a detailed image of the receivables and payables in real time.
Table of contents
- Accrual accounting is a method of accounting where revenue and/or expenses are recorded when a transaction occurs or when a payment is made.
- Most common examples of Accrual accounting are Sales on credit, purchase on credit, rent paid, electricity expense, depreciation, audit fees, etc.
- Accrual accounting is used to give a clear picture by showing the real-time happenings of the business. It also helps investors make decisions and judgments about the business’s present and future.
How Does Accrual Accounting Work?
Accruals in Accounting are the expenses or revenues that have been recorded by the firm but not yet realized. The major reason for using accrual accounting is to get a fair and accurate picture of the business at any given stage. As a key stakeholder of the business, one would want to know where a business stands at any given point in time. They would want to know how a business is doing currently, not what a business is due to receive in the near future. If a company is using the accrual basis of accounting, then as an investor, one can be sure that the company’s current affairs are the most accurate.
The accrual accounting method 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, it will show the same as sales even if the money is yet to be received.
Moreover, a vital point to note is that it is applicable for relatively medium to large businesses which earn a considerable amount ofCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. during any year.
Let us understand the usage of accrual accounting principles and practical concepts through the points below:
#1 – Accounts Payables
Difference Ltd. has salaries payableSalaries PayableSalary payable refers to the liability of the company towards its employees against the amount of salary of a period that became due but has not been paid yet to them by the company and it is shown in the balance of the company under the head liability. of $40,000.
The effect of this transaction would be two-dimensional. That means one needs to record this transaction in two places.
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 company’s balance sheet.
Let us now look at a practical example. Below is the snapshot of Colgate’s Current LiabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc.. We note that Colgate has reported accounts payables of $1,124 million in 2016 and $1,110 million in 2015. Accounts payablesAccounts PayablesAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period. primarily consist of salary payables.
source: Colgate SEC Filings
#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.
First, it will record it as a wage expense in the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.. It also shall be recorded as prepaid wages under the current assets of the balance sheetCurrent Assets Of The Balance SheetCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc..
Below is the snapshot of the Facebook Balance Sheet. It can be noted that Facebook has reported prepaid expensesPrepaid ExpensesPrepaid expenses refer to advance payments made by a firm whose benefits are acquired in the future. Payment for the goods is made in the current accounting period, but the delivery is received in the upcoming accounting period. of $959 million and $659 million in 2016 and 2015, respectively.
source: Facebook SEC Filings
#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 salesCredit SalesCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment. . 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 soldCost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. and the operating expenses.
It is important to note that credit sales would not be accounted if it were cash accounting.
Below is an example from Colgate’s Balance Sheet. We note that Colgate has reported accounts receivablesReported Accounts ReceivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. of $1,411 million on $1,427 million in 2016 and 2015, respectively.
source: Colgate SEC Filings
The following section refers to the financials of Amazon. Let us understand the numbers by applying accrual accounting principles:
Here, one can observe that in the Accounts receivables section, the firm has recorded the 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 riskA Credit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection. involved as there is an element of uncertainty. Therefore, the firm has also recorded Bad debt or doubtful accounts. It is a good Accounting practice is a set of procedures and controls used by an entity's accounting department to keep track of accounting records and entries. Other reports are generated based on accounting records, such as financial statements, cash flow statements, fund flow statements, payroll, tax workings, payment and receipts statements, and so on, and they form the basis of the auditor's reliance while auditing the financial statements.accounting practiceAccounting PracticeAccounting practice is a set of procedures and controls used by an entity's accounting department to keep track of accounting records and entries. Other reports are generated based on accounting records, such as financial statements, cash flow statements, fund flow statements, payroll, tax workings, payment and receipts statements, and so on, and they form the basis of the auditor's reliance while auditing the financial statements. and helps remove the ambiguity of the accrual-based revenues.
Advantages & Disadvantages
The Accrual accounting method has its own share of advantages and disadvantages in its application, accounting, and relevance. Let us understand them through a comparison below:
- It is a holistic approach: Accrual accounting is a comprehensive system, unlike cash accounting. You would agree that a business is not about cash only. Many aspects should be taken into account. Under the accrual system, we can record all the business’s financialA business transaction is the exchange of goods or services for cash with third parties (such as customers, vendors, etc.). The goods involved have monetary and tangible economic value, which may be recorded and presented in the company's financial statements. transactions TransactionsA business transaction is the exchange of goods or services for cash with third parties (such as customers, vendors, etc.). The goods involved have monetary and tangible economic value, which may be recorded and presented in the company's financial statements. (cash and others). We can also create financial statements like the income statement and balance sheet to get a more holistic view of how a company is doing.
- 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 systemDouble-entry SystemDouble Entry Accounting System is an accounting approach which states that each & every business transaction is recorded in at least 2 accounts, i.e., a Debit & a Credit. Furthermore, the number of transactions entered as the debits must be equivalent to that of the credits. . That means one account is debitedDebitedDebit represents either an increase in a company’s expenses or a decline in its revenue. 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.
- 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 systemAccounting SystemAccounting systems are used by organizations to record financial information such as income, expenses, and other accounting activities. They serve as a key tool for monitoring and tracking the company's performance and ensuring the smooth operation of the firm. isn’t an easy job as well.
- Holistic but challenging to maintain: A business has different aspects. And if a business is enormous, in a single day, hundreds and thousands of financial transactions need to be recorded under this accounting. Maintaining all of these daily, day after day, isn’t an easy job for an accountant.
Accrual Accounting Basis Video
Frequently Asked Questions (FAQs)
The accrual basis of accounting has four different types: Accounts Receivables, Accounts Payable, Accrued Revenue, and Accrued Liabilities.
Out of the two, accrual accounting is a golden standard of accounting because it provides a precise analysis of the company’s fiscal state. Due to this, cash accounting is less preferred in current times.
Regardless of when they receive payment, firms that use the accrual method of accounting to report their income taxes in the year they recognize the revenue. In addition, they write off their costs in the tax year they are incurred, regardless of when payments are made.
Yes, accrual accounting poses some difficulties such as deception of the company records because some businesses misuse this method to hide their weaknesses. However, accrual accounting is beneficial when done in the right manner.
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