source: Colgate SEC Filings
What is Accrual Accounting Basis?
Accrual accounting basis is one of the most accepted methods in accounting. In accrual accounting, the revenue is recognized when the sale is done (irrespective of the cash or credit sale) and the expense is recognized when it is incurred (irrespective of whenever it’s paid).
Accrual accounting is used by most business owners.
As per accrual accounting, the accountant records an expense or revenue when it occurs. It has nothing to do with cash inflow or the time of the cash inflow.
Accrual accounting is based on one accounting principle, i.e. matching principle.
As per the matching principle, one needs to record the expense in correspondence with the revenue.
For example, as a business owner, if you record the sales, you also need to record the cost of goods sold at the same time.
But why most businesses use accrual accounting basis?
The main reason for using accrual accounting 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 in near future. 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 is the most accurate or not.
Accrual basis of accounting showcases exactly what is happening in the business, not what a business will achieve in the near future. For example, if a firm has sold products on credit, accrual basis of accounting will show the same as sales even if the money is yet to be received by the company.
Another important point about the accrual basis of accounting is that accrual accounting basis is applicable for businesses which are relatively medium to large and which earn a decent amount of cash flow during any year.
If you are new to accounting, you may have a look at this basic accounting training tutorial
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A measuring grid for accrual basis of accounting
There’s not always an exact figure to find out whether you should use cash accounting or accrual basis of accounting.
But still, there is a structure that is being followed in the market. You can call it a rule or a guideline. Here it is –
If your business is selling more than $5 million in a year and if you are a corporation, then you should go for accrual basis of accounting.
Otherwise, you should choose cash accounting.
You may ask – why?
It is a general rule. The reason behind this is the number of transactions.
In the case of sole proprietorship and lesser revenue, the numbers of transactions are fewer. That’s why in this case cash accounting is great.
But for the corporation and large revenue, the numbers of transactions are so many that the accrual basis of accounting is best.
Accrual Accounting Examples
Let’s look at a few practical examples of accrual accounting basis.
Accrual Basis Accounting Example#1 – Accounts Payables
Difference Ltd. has salaries payable of $40,000. How would we treat it as per the accrual basis of accounting?
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.
First, it would be recorded as salaries 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 of the accrual basis of accounting. 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 salaries payables.
source: Colgate SEC Filings
Accrual Basis Accounting 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.
As per the accrual basis of accounting, we will treat in a similar way.
We will record the transaction in two places.
First, we will record it as wages expense in the income statement. And we will also record prepaid wages under the current assets of the balance sheet.
Let us now look at another practical example of an accrual accounting basis. Below is the snapshot of 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
Accrual Accounting Basis 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?
As per the accrual basis of accounting, 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 of Accrual Basis Accounting taken 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
Advantages of Accrual Accounting
There are many benefits of accrual accounting. Let’s have a look at them –
- It is a holistic approach: Unlike cash accounting, accrual accounting is a holistic accounting system. You would agree that a business is not about cash only. There are many aspects that should be taken into account. Under 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 almost no chances of discrepancies or errors. And since everything is recorded all the time, if one wants to do an audit, the information is easily available.
- Accuracy level is higher: Unlike cash accounting, accrual accounting follows 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 audit, things get easier.
- It is recognized by Companies Act: Another benefit of accrual accounting is that it is recognized by Companies Act and that’s why a huge number of companies follow accrual accounting instead of cash accounting.
Disadvantages of Accrual Accounting
Accrual accounting also has a few disadvantages. Here are they –
- Quite complex: Cash accounting is easy to record and easy to maintain. But accrual accounting is very difficult 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 difficult to maintain: A business has different aspects. And if a business is huge, in a single day hundreds and thousands of financial transactions need to be recorded under accrual accounting. Maintaining all of these every day, day after day isn’t an easy job for any accountant.
Accrual Accounting Basis Video
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This has been a guide to Accrual Accounting basis, their examples and its key differences from Cash Accounting. You may also have a look at these articles for enhancing your knowledge in accounting –
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