Accrual basis of accounting

What Is Accrual Basis of Accounting?

The accrual basis of accounting is a fundamental accounting method that recognizes revenues when they are earned and expenses when they are incurred, regardless of when cash actually changes hands. This approach falls under the broader category of accounting principles and aims to provide a more accurate depiction of a company's financial performance over a specific period. It contrasts sharply with the cash basis of accounting, which records transactions only when cash is received or paid. Accrual accounting is essential for generating robust financial statements that reflect the true economic activities of a business.

This method aligns with key concepts such as the revenue recognition principle and the matching principle, ensuring that revenues and the expenses incurred to generate those revenues are recorded in the same accounting period. By doing so, the accrual basis of accounting offers a more complete view of a company's profitability and financial position, going beyond mere cash movements.

History and Origin

The evolution of modern accounting practices, including the widespread adoption of the accrual basis, is closely tied to the increasing complexity of business transactions, particularly the rise of credit sales and long-term projects. As businesses grew beyond simple cash-for-goods exchanges, the need for a method that could better reflect a company's financial standing and future obligations became apparent.

Major accounting standard-setting bodies, such as the Financial Accounting Standards Board (FASB) in the United States and the International Accounting Standards Board (IASB) globally, have formalized the accrual basis of accounting as the preferred and often mandatory method for financial reporting. In the U.S., the Generally Accepted Accounting Principles (GAAP), issued by the FASB, require public companies to use accrual accounting¹⁶. Similarly, the International Financial Reporting Standards (IFRS), issued by the IASB, also mandate the use of the accrual basis of accounting for financial statements, with the exception of cash flow information¹⁰, ¹¹, ¹², ¹³, ¹⁴, ¹⁵. This global consensus underscores the importance of the accrual basis in providing a consistent and comprehensive view of financial performance.

Key Takeaways

• Accrual basis accounting records revenues when earned and expenses when incurred, regardless of cash flow.
• It provides a more accurate and comprehensive picture of a company's financial health and profitability.
• The method adheres to the revenue recognition and matching principles.
• Publicly traded companies in most major economies are required to use accrual accounting under standards like GAAP and IFRS.
• It facilitates better long-term financial planning and decision-making for stakeholders.

Formula and Calculation

The accrual basis of accounting does not involve a specific formula in the traditional sense, but rather a set of principles and adjusting entries that impact how financial transactions are recorded. The core concept revolves around the timing of recognition for revenues and expenses.

• Revenue Recognition: Revenue is recognized when it is earned, meaning goods have been delivered or services have been performed, regardless of when payment is received. If payment is not yet received, an accounts receivable is created.
• Expense Recognition: Expenses are recognized when they are incurred, meaning a liability has been created or an economic benefit has been consumed, regardless of when the payment is made. If payment is not yet made, an accounts payable is created.

Adjusting entries are crucial in accrual accounting to ensure that revenues and expenses are matched to the correct accounting period. These entries include:

• Accrued Revenues: Revenues earned but not yet received.
• Accrued Expenses: Expenses incurred but not yet paid.
• Deferred Revenues (Unearned Revenues): Cash received for goods/services not yet delivered.
• Prepaid expenses: Cash paid for expenses not yet incurred.

For instance, if a company pays for a year of insurance upfront, under the accrual basis, only one month's worth of insurance expense would be recognized each month, with the remainder treated as a prepaid expense on the balance sheet.

Interpreting the Accrual Basis of Accounting

Interpreting financial information prepared under the accrual basis of accounting requires understanding that it presents the economic reality of a company's operations, even if cash hasn't exchanged hands. This method provides insight into an entity's ability to generate earnings and manage its obligations over time. For example, a high volume of accounts receivable on the balance sheet indicates sales have been made, and revenue earned, even if the cash has not yet been collected. Conversely, a significant amount of accounts payable suggests expenses have been incurred, leading to obligations that will require future cash outflow.

This allows stakeholders to assess a company's true operational profitability by matching revenues with the expenses directly related to generating them, rather than being skewed by the timing of cash receipts and payments. It helps users of financial statements understand a company's capacity for generating future cash flows and its management of economic resources and claims⁹.

Hypothetical Example

Consider "BuildWell Construction Inc.," a company that completes a building project for a client on December 20, for which they bill $500,000. The client agrees to pay the full amount on January 15 of the following year.

Under the accrual basis of accounting:

1. December 20 (Year 1): BuildWell Inc. recognizes $500,000 in revenue because the service (building completion) has been rendered. At the same time, they record a $500,000 accounts receivable.
   • Journal Entry (December 20, Year 1):
     • Debit Accounts Receivable: $500,000
     • Credit Revenue: $500,000
       This entry impacts the income statement of Year 1, showing the earned revenue, and the balance sheet, reflecting the asset (money owed).
2. January 15 (Year 2): BuildWell Inc. receives the cash payment.
   • Journal Entry (January 15, Year 2):
     • Debit Cash: $500,000
     • Credit Accounts Receivable: $500,000
       This entry affects the cash flow statement in Year 2, showing the cash inflow, and reduces the accounts receivable on the balance sheet. No new revenue is recognized in Year 2 for this transaction.

This example highlights how accrual accounting allocates revenue to the period in which it was earned, providing a clearer picture of the company's performance for Year 1, even though the cash was received later.

Practical Applications

The accrual basis of accounting is the backbone of modern financial reporting and is widely used across various sectors of the economy.

• Corporate Financial Reporting: Publicly traded companies in the United States are mandated by the Securities and Exchange Commission (SEC) to prepare financial statements using GAAP, which relies on the accrual method⁸. This ensures comparability and transparency for investors and other stakeholders. Similarly, companies adhering to IFRS standards globally also use accrual accounting⁶, ⁷.
• Taxation: While many small businesses and individuals may use the cash method for tax purposes, larger corporations and businesses involved in the sale of merchandise are generally required by the Internal Revenue Service (IRS) to use an overall accrual method of accounting for income tax purposes⁴, ⁵.
• Investment Analysis: Financial analysts heavily rely on accrual-based financial statements, including the income statement, balance sheet, and cash flow statement, to evaluate a company's profitability, solvency, and liquidity. The accrual basis of accounting provides a more complete picture of a company's underlying economic performance, aiding in more informed investment decisions.
• Governmental Accounting: While primarily focused on modified accrual, governmental entities often transition towards or utilize aspects of accrual accounting, particularly for enterprise funds, to enhance transparency and financial accountability³.

The universal application of the accrual basis underscores its importance in providing a faithful representation of a company's financial health, regardless of the timing of cash flows.

Limitations and Criticisms

While widely regarded for its comprehensive financial picture, the accrual basis of accounting is not without its limitations and criticisms. One primary critique is its potential disconnect from actual cash flow. A company might report high profits on an income statement under the accrual basis due to significant sales on credit (leading to high accounts receivable), but simultaneously face a cash shortage if those receivables are not collected promptly. This can lead to liquidity issues, even for seemingly profitable entities.

Another limitation arises from the judgments and estimates inherent in accrual accounting. Determining when revenue is "earned" or an expense is "incurred" often involves management's discretion, such as estimating bad debts or the useful life of an asset for depreciation. Such estimates can introduce subjectivity and, if abused, can lead to financial statement manipulation. For instance, improper capitalization or deferral of expenses, or failure to record losses, can distort reported net income, as highlighted in reports on accounting practices².

Furthermore, the complexity of accrual accounting, especially for smaller businesses, can be a drawback. It requires a more sophisticated accounting system and skilled personnel to track accrued revenues, accrued expenses, deferred revenue, and other adjusting entries, which can be more costly to implement compared to simpler cash basis accounting.

Accrual Basis vs. Cash Basis of Accounting

The fundamental distinction between the accrual basis of accounting and the cash basis of accounting lies in the timing of recognizing revenues and expenses.

While the cash basis is straightforward and often suitable for very small businesses or personal finance, the accrual basis of accounting offers a more comprehensive and realistic view of a company's financial health by matching revenues with the expenses that generated them, regardless of when cash physically moves. This makes accrual accounting indispensable for larger entities and for providing a complete picture for investors and creditors.

FAQs

What is the primary difference between accrual and cash basis accounting?

The primary difference is timing. Accrual accounting recognizes revenues when earned and expenses when incurred, regardless of cash flow. Cash basis accounting recognizes revenues and expenses only when cash is received or paid.

Why is accrual basis accounting preferred for larger businesses?

Accrual accounting is preferred because it provides a more accurate and complete picture of a company's financial performance and position over a given period. It aligns revenues with related expenses, offering better insights into true profitability, and is mandated by major accounting principles like GAAP and IFRS.

Does accrual accounting require complex calculations?

While it involves more steps than cash basis accounting, particularly with adjusting entries for items like prepaid expenses and deferred revenue, the calculations themselves are not inherently complex. The complexity arises from tracking numerous non-cash transactions to ensure proper timing of recognition.

Can a small business choose to use accrual basis accounting?

Yes, a small business can choose to use accrual basis accounting. In fact, many small businesses transition to accrual accounting as they grow and their financial transactions become more complex, especially if they extend credit to customers or incur expenses on credit. For tax purposes, specific rules apply, with some small businesses exempt from the accrual method requirement¹.

How does accrual accounting affect the financial statements?

Accrual accounting affects all primary financial statements. It determines what revenues and expenses appear on the income statement for a given period, and it leads to the recognition of non-cash assets (like accounts receivable) and liabilities (like accounts payable) on the balance sheet, offering a complete view of a company's economic resources and obligations.