Accrual basis accounting

What Is Accrual (Basis) Accounting?

Accrual (basis) accounting is an accounting method that records revenues when they are earned and expenses when they are incurred, regardless of when cash actually changes hands. This method is a core component of Financial Accounting and aims to provide a more accurate representation of a company's financial performance over a given period. Unlike systems that focus solely on cash transactions, accrual accounting includes non-cash items like accounts receivable (money owed to the company) and accounts payable (money the company owes). The fundamental principle behind accrual accounting is the matching principle, which dictates that expenses should be recognized in the same period as the revenues they helped generate. This method is crucial for understanding the true profitability and financial health of a business.

History and Origin

The evolution of accrual accounting is closely tied to the development of standardized financial reporting. As businesses grew more complex and transactions moved beyond simple cash exchanges, the need for a system that more accurately matched revenues and expenses became apparent. The formal adoption and widespread use of accrual accounting gained significant momentum with the establishment of Generally Accepted Accounting Principles (GAAP) in the United States. Key milestones in this development include the Securities Exchange Act of 1934, which required companies listed on public exchanges to adhere to GAAP standards¹⁰. Later, the creation of the Financial Accounting Standards Board (FASB) in 1973 provided an independent body responsible for setting and updating these accounting standards, further solidifying the mandate for accrual accounting for many entities⁹,⁸.

Key Takeaways

• Accrual accounting records revenues when earned and expenses when incurred, irrespective of cash movements.
• It provides a more accurate view of a company's profitability and financial health over time.
• This method requires tracking non-cash transactions like accounts receivable and accounts payable.
• Accrual accounting is mandated for many businesses, particularly larger ones and publicly traded companies, under GAAP.
• It helps in matching expenses to the revenues they generate, adhering to the matching principle.

Interpreting Accrual (Basis) Accounting

Interpreting financial information prepared under accrual accounting provides a comprehensive view of a company's operational performance and long-term financial position. By recognizing revenue recognition when it's earned and expense recognition when incurred, even if cash hasn't exchanged hands, this method allows stakeholders to understand underlying economic events. For example, a company might have significant sales on credit, which are immediately recognized as revenue under accrual accounting, leading to higher reported profits. However, this doesn't mean the company has the corresponding cash readily available. Similarly, expenses for goods received but not yet paid for are recorded as liabilities, providing a clearer picture of future obligations. This method is fundamental for preparing the income statement and balance sheet, offering insights into a business's true earning capacity and financial structure rather than just its immediate cash position.

Hypothetical Example

Consider "BuildWell Construction," a small business that completes a roofing project for a client in December for $10,000. BuildWell sends the invoice in December, but the client pays in January of the following year.

Under accrual accounting:

• December: BuildWell recognizes $10,000 in revenue because the service was performed and earned in December, even though cash hasn't been received. This creates an accounts receivable entry of $10,000 on the balance sheet.
• January: When the client pays, the cash account increases, and the accounts receivable account decreases. No new revenue is recognized for January, as it was already accounted for in December.

Similarly, if BuildWell buys $2,000 worth of materials on credit in December but pays the supplier in January:

• December: BuildWell recognizes $2,000 in expense (cost of materials) because the materials were incurred in December. This creates an accounts payable entry of $2,000.
• January: When BuildWell pays the supplier, the cash account decreases, and the accounts payable account decreases. No new expense is recognized for January.

This example illustrates how accrual accounting matches the economic activities (earning revenue and incurring expenses) to the period in which they occur, providing a more accurate representation of the company's performance for each month.

Practical Applications

Accrual accounting is widely applied across various aspects of finance and business operations, serving as the backbone for robust financial statements. Publicly traded companies in the United States are required to use accrual accounting under GAAP, ensuring consistency and comparability in their financial reports for investors and regulators. The Securities and Exchange Commission (SEC), for example, oversees financial reporting for public companies, relying on accrual methods for accurate disclosures.

For tax purposes, while some small businesses may use the cash method, the Internal Revenue Service (IRS) generally requires businesses above a certain revenue threshold (e.g., $25 million in gross receipts) to use the accrual method for their income tax filings, especially if they maintain inventory⁷,. This is detailed in IRS publications such as Publication 538, "Accounting Periods and Methods"⁶.

In financial analysis, investors and analysts rely on accrual-based financial statements to assess a company's true profitability, asset utilization, and liability management. It provides a more comprehensive picture for strategic planning, budgeting, and evaluating long-term viability, distinguishing it from simply tracking immediate cash flows.

Limitations and Criticisms

Despite its advantages in providing a comprehensive financial picture, accrual accounting has certain limitations and faces criticisms. One primary drawback is its potential to obscure a company's immediate cash position. A business might report significant profits under accrual accounting due to large accounts receivable, yet struggle with liquidity if those payments are delayed⁵,⁴. This disconnect between reported profits and actual cash on hand can make it challenging for management to assess short-term cash availability for operational needs or debt obligations.

Another criticism is the increased complexity it introduces into bookkeeping and financial management. Accrual accounting necessitates careful tracking of various non-cash entries, such as prepaid expenses and unearned revenue, and requires more judgment and estimation than the simpler cash method³. This complexity can lead to a higher administrative burden and may require professional accounting expertise, potentially increasing costs for smaller organizations²,¹. Errors in categorizing or timing entries can distort financial statements and lead to compliance issues.

Accrual (Basis) Accounting vs. Cash (Basis) Accounting

The fundamental difference between accrual (basis) accounting and Cash basis accounting lies in the timing of revenue and expense recognition. Accrual accounting recognizes revenue when it is earned and expenses when they are incurred, regardless of when the associated cash is received or paid. This means that a sale made on credit is recorded as revenue at the time of the sale, and an expense for services received but not yet paid is recorded when the service is rendered. This method provides a more accurate reflection of a company's profitability over a specific period, as it matches revenues with the expenses used to generate them.

In contrast, Cash basis accounting records revenues only when cash is actually received and expenses only when cash is actually paid out. For instance, in Cash basis accounting, a credit sale would not be recorded as revenue until the customer's payment is received. Similarly, an expense is not recognized until the bill is paid. This method is generally simpler to maintain and provides a clearer picture of a company's immediate cash flow, which can be beneficial for very small businesses or sole proprietorships without complex inventory or credit transactions. However, Cash basis accounting may not accurately represent a company's overall financial performance or long-term profitability. Most large businesses and publicly traded companies are required to use accrual accounting due to its comprehensive nature and adherence to Generally Accepted Accounting Principles.

FAQs

Why is accrual accounting considered more accurate?

Accrual accounting is considered more accurate because it matches revenues to the expenses incurred to generate those revenues within the same accounting period, regardless of when cash changes hands. This provides a clearer picture of a company's true financial performance and profitability over a given period, rather than just its cash movements.

What are accruals and deferrals in accrual accounting?

Accruals refer to revenues earned or expenses incurred for which cash has not yet been received or paid. For example, accounts receivable is an accrued revenue, and accounts payable is an accrued expense. Deferrals refer to cash received or paid for which the revenue has not yet been earned or the expense has not yet been incurred. Examples include unearned revenue (cash received for future services) and prepaid expenses (cash paid for future benefits).

Is accrual accounting required by law?

For many businesses, particularly larger ones and publicly traded companies, accrual accounting is required by law or regulatory bodies. In the U.S., it is mandated under Generally Accepted Accounting Principles (GAAP) for public companies and by the IRS for businesses exceeding certain gross revenue thresholds or those that carry inventory.

How does accrual accounting impact a company's financial statements?

Accrual accounting directly impacts a company's financial statements, particularly the income statement and [balance sheet]. It ensures that the income statement accurately reflects revenues earned and expenses incurred during a period, leading to a more meaningful net income figure. The balance sheet will show assets like accounts receivable and liabilities like accounts payable, providing a complete view of the company's financial position, including money owed to it and by it. The cash flow statement then reconciles the accrual-based net income to the actual cash generated or used.