Accrual Accounting Explained

June 13, 2022

Accrual Accounting Explained

Accrual-based Accounting adjusts the Revenues Earned and Expenses Incurred by a company at the end of a period when no Cash has been exchanged. The transactions would not be recorded in the company’s Books of Accounts under the Cash basis of Accounting, since there’s been no Inflow and Outflow of Cash.

What is an Example of an Accrued Expense?

An Example of an Accrual Expense in Accrual-based Accounting involves Bonuses that were Liable in 2021, but will not be paid until 2022. The 2021 financial statements need to reflect the Bonus Expense due to employees in 2021 as well as the Bonus Liability the company plans to pay out in 2022. That means, prior to issuing the 2021 Financial Statements, an Adjusting Journal Entry records this Accrual with a Debit to a Bonus Expense account and a Credit to a Liability account. Once the payment has been made in 2022, the Liability Account will be decreased through a Debit, and the Cash or Bank Account will be reduced through a Credit.

What is the Difference Between Cash and Accrual Accounting?

You might be wondering what the difference Cash vs Accrual accounting is.

Cash and Accrual methods differ based on the timing of when Income and Expenses are recorded in your accounts. In case of Cash accounting revenue and expenses gets recognized only when money received or spent, but in case of Accrual accounting revenue and expenses recognized when it is earned or billed (but not based on payment).

BASIS FOR COMPARISON

CASH ACCOUNTING

ACCRUAL ACCOUNTING

Definition

Income and Expenses get recognized based on Inflow or Outflow of Cash.

Income and Expenses get recognized based on event occurrence.

Nature of Method

Simple and Not recognized Method

Complex and Recognized Method

Income Statement

The Income statement shows a lower income.

The income statement will show a comparatively higher Income.

Matching Concept

Violated

Not Violated

Revenue Recognition

Cash Receipt

Earned

Expense Recognition

Cash Payment

Incurred

Accuracy Level

Low

Comparatively High

 

What are the Two Main Principles of Accrual Accounting?

A business that uses the Accrual basis of Accounting recognizes Revenue and Expenses in the Accounting period in which they are earned or incurred, regardless of when payment occurs. This differs from the Cash basis of Accounting, under which a business recognizes Revenue and Expenses only when Cash is Received or Paid. Two concepts, or principles, that the Accrual basis of Accounting uses are the Revenue Recognition Principle and the Matching Principle.

Revenue Recognition Principle

Revenue is earned by selling products and services to customers. As per Revenue Recognition principle a business must Recognize Revenue in the period when Sales occurs, even though the collection from the Customer is in a different period. 

For example, the business provides the services to a Customer for $1000 at the end of the current year. Assume you bill the customer and expect to pay you next year. Under the Revenue Recognition principle, you would recognize the full $1000 as Revenue in your records in the current year because the services are provided in the current year. The timing of the payment in the next year does not affect when you record the Revenue.

Matching Principle

The Matching Principle is a basic accounting principle that is adhered to in order to ensure consistency in a company's Financial Statements: i.e. the Income Statement, Balance Sheet, etc. A company match Expenses and Revenues in the same accounting period. Expenses should not be recorded when they are paid, but rather at the same time as the Revenue. It's an Accounting concept that requires any cause-and-effect relationship between the Expenses and Revenues to be recorded simultaneously.

For example, Selling the goods to customers will increase Revenue and decrease Inventory. The reduction in Inventory matching with Revenue is called the Cost of Goods Sold.

What are the Major Reasons for Accrual Accounting?

1. Improving Financial Strength

Accrual Accounting easily allows the business owner to see at a glance if the company is profitable, where the profit is coming from, and where expenses are going.  Accrual accounting also matches revenues with the expenses the company incurred to produce it.

2. Being GAAP Compliant

In the United States, GAAP (Generally Accepted Accounting Principles) is the industry standard for preparing Financial Statements. Meeting GAAP allows a company’s financial picture to be easily accessed by Investors and Other Financial Institutions.

3. Maintaining Accuracy

Accrual Accounting gives companies a truer depiction of their resources and financial responsibilities. This serves as a company advantage because it allows businesses to properly manage the ebb and flow of Financial activity. Professionals can assess income and debts more accurately with Accrual Accounting.

4. Planning the Future

Cash Accounting is an kind of after the fact accounting style, while Accrual Accounting is in real-time. Accrual Accounting makes it easy for business managers to plan for the future.

Professionals can find ways to improve sales or generate more revenue as they do not have to wait for cash to see the profitability. It keeps a company progressive.

5. Facilitating Credit

To expand, or survive, the most businesses will depend on credit.  Accrual Accounting helps companies to record and become creditworthy – both credits owing as well as owed.

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