What Is Accrual Based Accounting?

One of the critical responsibilities of business owners and accountants is selecting an accounting technique to record transactions. Accrual-based accounting is one of two major accounting procedures and the most often used bookkeeping approach for obtaining an accurate financial picture of a company’s operations. When financial reports are prepared under the Generally Accepted Accounting Principles, the accrual foundation of accounting must be used.

Outline 

• What is accrual-based accounting?

• Principles of accrual accounting

• Types of accrual-based accounting.

• Advantages

• Disadvantages

• key takeaways

What is Accrual based Accounting?

Accrual-based accounting is the concept in which transactions and events are recognized or reported as they happen not when cash is received or paid, as compared to cash basis accounting in which transactions are recognized or reported only when cash is received or paid. This method follows the accrual principle which states that revenues and expenses should be recognized in the same period.

The concept of the accrual basis of accounting can be summarized as;

Principles of accrual accounting

Accrual accounting consists of two principles. The two principles are part of the generally accepted accounting principle (GAAP).

Revenue recognition principle: According to the revenue recognition principle, you should only record income when earned, not when you receive associated cash.

Matching principle: According to the matching principle, you should match related revenues and expenses in the same period. This theory emphasizes that in order to generate revenue, companies must incur expenses.

Types of Accrual Based Accounting

There are various types of accrual accounts. The most common include accrued revenues and accrued expenses.

Accrued Revenues

Accrued Revenues are revenues collected by a corporation in the normal course of business after selling a product or providing services to the customer for which payment has not yet been received. It follows the generally accepted accounting principle (GAAP) which specified that it doesn’t matter whether you receive cash at the time, revenue is recognized when a customer takes ownership of a good or receives a service.

Accrued revenue is represented on the financial statements as an adjusting journal entry on the balance sheet under current assets and on the income statement under earned revenue.

The purpose of an accrued revenues journal entry is to recognize the revenues 

For example;

Let’s say company XYZ has a consulting project with a large client, under which the consulting agreement clearly delineates a milestone,  in which the client owes $12,000 to the company at the end of the project. The milestone is for the month of January, the company must create the following journal entry to record the revenues:

At the end of the next month, the XYZ company completes the milestone and bills the client for $12,000.  On the day when clients paid to the company, cash will debit, and accrue revenue will credit. The company will create the following journal entry:

Accrued expenses

The term “accrued expense” refers to a cost that has already been incurred but for which payment has not yet been paid. 

The purpose of accrued expenses journal entry is to recognize the expenses that the company incurs over a period of time but are unpaid by the company.

For example;

Let’s say a company XYZ purchased goods worth $8,000 from Hamdan limited on the 31st of January 2022 but didn’t pay for it at the time of purchase. As per the matching principle, XYZ company will record the expenses of $8000 in the financial year ending on 31^st January 2022, even though they receive the payment in the next accounting period.

The accounting entry on the day of payment, let’s say 10^th march 2022 will be debit accounts payable and credit cash. The company will record the following journal entry.

Advantages 

• The accrual basis of accounting provides a more accurate portrayal of a company’s current financial situation, and it is a more preferred accounting technique.
• There are essentially no chances of inconsistencies or inaccuracies because the accountants promptly records financial transaction as it occurs.
• Accrual accounting provides businesses with instant information on predicted cash inflows and outflows, making it easier to manage existing resources.
• Investors consider the accrual basis of accounting to be the most accurate accounting method for determining a business’s results of operations, financial condition, and cash flows. This is because it provides more consistent reporting of revenues and expenses over time.
• Accrual accounting gives managers a clearer perspective of the future. This allows them to work on ways to improve their outlook and discover areas for improvement.

Disadvantages

• Accrual accounting is difficult to record because every time a financial transaction occurs, you need to make an entry in the books of accounts. Maintaining the entire accounting system is a difficult task.
• The accrual basis may be challenging for a small business to use because it necessitates considerable expertise in accounting systems. Small businesses may find it more practical to begin with the simpler cash basis of accounting.

Key takeaways 

• Accounting provides a more accurate and clear picture of a company’s performance and financial situation by tracking revenue and expenses as they occur.
• There are two principles of accrual accounting: the revenue recognition principle and the matching principle. These two principles are part of the generally accepted accounting principle (GAAP).
• Accrued revenue and accrued expenses are the most common types of accrual accounting.

• Accrual-based accounting provides accurate information about the financial health of a company and is used by the owner and investors to determine the current situation of the company and to predict future cash flow.