Many professionals find accrual accounting more accurate and informative, providing a complete picture of a company's financial health. However, the principles behind accrual accounting can be confusing for those who are not familiar with them.
This blog post will explain what accrual accounting is and how it works. We will also discuss some of its advantages and presentation. Finally, we will provide an example to help illustrate how accrual accounting works.
What is accrual accounting?
Accrual accounting is a system of bookkeeping where revenue is recognized when earned, and expenses are recorded when they are incurred in the income statement. As opposed to the cash basis of accounting, which records revenue when it is received and expenses when they are paid.
This matching principle of revenue and expenses give insights into a company's financial statement and bottom line.
In December, you sell some goods on credit. You receive cash from your client in February. You record the sale in December, not when you receive the money. This leads to the creation of accounts receivable on the balance sheet.
In December, cash payment was made for office rent for January to March. The rent cost is to be expensed over these three months, not just in full in the month it was paid.
The objective of accrual accounting
Accrual accounting provides a more realistic representation of economic activity than cash transaction reporting. The underlying thought is that a completed transaction is the culmination of a series of preceding activities.
The effect of the extension of the accrual concept is to eliminate the peaks and valleys which may arise under cash transaction accounting. For example,
- Income taxes are more evenly spread over by deferred income tax accounting.
- The impact of obsolescence is spread over several periods by functional depreciation.
How economic activities impact accrual accounting
The accrual process accounts for economic activities between transactions or activities leading up to a transaction. A purchase transaction may initiate economic activity. A sales transaction may terminate. But accountants must rely upon the accrual process to reveal economic activity between the initial and final transactions.
As an example, economic activity may be initiated with the expectation of a future transaction,
- Such as an employee starting his work with the expectation that he will be paid later. or
- The recording of the activities between acquiring a fixed asset and selling the fixed asset. This is done through depreciation accrual.
The accrual process reveals the economic activity before the final exchange transaction.
Difference between accrual accounting and cash-based accounting
- Accrual is done during the period of economic activity or transaction. In cash basis accounting, accounting is done only when money is exchanged.
- GAAP and IFRS do not permit cash basis accounting. Under taxation ((depending on the country), however, companies may elect to present financial statements as either under accrual or cash.
Examples of accrual accounting
Some of the regular accruals that companies do employ are
- Revenue recognition
- Warranty expenses
- Employee long-term benefit expenses
- Provision for doubtful debts
- accounts payable
- accounts receivable
Accountants must review these accruals at every reporting period to reflect the economic activities incurred.
Benefits of accrual accounting
It provides a more accurate picture of a company's financial health. If income is only reported when cash is received, a company may appear to be doing better than it is. By matching expenses with the corresponding revenue, on the other hand, accrual accounting gives a more accurate picture of profitability.
Accrual accounting also serves the needs of less well-informed investors. Uninformed investors tend to rely on reported annual income as a parameter of the Company's health.What is the main disadvantage of accrual accounting?
The main disadvantage of accrual accounting is that it can be more complex and challenging to understand than cash accounting. Accrual accounting records revenue and expenses as earned or incurred, even if the associated cash has not yet been received or paid. This can make financial statements harder to read and analyze.
Accrual accounting is generally considered a more accurate way of recording financial transactions since it considers the timing of revenue and expenses. However, some businesses find it harder to track their cash flow when using this method.
Accrual concept and matching concept
The accrual concept is the accounting principle that requires companies to recognize revenue and expenses when they are incurred, regardless of when the payment is received or made. The matching concept is the related principle that requires costs to be matched with the revenue they helped generate. Together, these concepts ensure that a company's financial statements give a true and accurate picture of its financial health.
Accrual accounting under IFRS
IAS 1 Presentation of financial statements requires financial statements, except for cash flow, to be prepared using the accrual basis of accounting.
Examples of disclosure of accrual concept in notes to accounts
"The financial statements have been prepared on accrual and going concern basis under the historical cost convention. Except for a certain class of financial assets/ liabilities, share-based payments and net liability for defined benefit plans are measured at fair value. The Company has consistently applied the accounting policies unless stated otherwise."
Where do the accruals appear on the balance sheet?
Accruals for expenses are debited from expense accounts and credited to accrued liabilities (which appear on balance sheets). If the accrued expenses are to be paid within one year, these are classified under current liabilities. If the expenses are to be paid after a year, these are classified as long-term liabilities.
Similarly, suppose you are recording revenue that is not received. In that case, you will be debiting accounts receivable which is shown under current assets on the balance sheet.