Accrual Basis of Accounting

What is the Accrual Basis of Accounting?

Definition: The accrual basis of accounting is a system of recognizing revenues and expenses when they are incurred instead of focusing on when they are paid or collected. This means that both revenues and expenses are recognized and recorded in the accounting period when they occur instead of when payments are actually made. GAAP requires businesses to use the accrual method because it more accurately reflects the financial position of a company than the cash basis.

The accounting method under which revenues are recognized on the income statement when they are earned (rather than when the cash is received). The balance sheet is also affected at the time of the revenues by either an increase in Cash (if the service or sale was for cash), an increase in Accounts Receivable (if the service was performed on credit), or a decrease in Unearned Revenues (if the service was performed after the customer had paid in advance for the service).

Under the accrual basis of accounting, expenses are matched with revenues on the income statement when the expenses expire or title has transferred to the buyer, rather than at the time when expenses are paid. The balance sheet is also affected at the time of the expense by a decrease in Cash (if the expense was paid at the time the expense was incurred), an increase in Accounts Payable (if the expense will be paid in the future), or a decrease in Prepaid Expenses (if the expense was paid in advance).

What Does Accrual Basis Mean?

What is the definition of accrual basis? This accounting method ignores when cash payments were actually sent or received. Instead, it is more concerned with the economic status of a transaction by focusing on when the revenues were earned and when the payments were owed. Under the accrual basis, income is only recognized and recorded when it is earned. Companies technically earn income when a service is provided or a product is delivered. Likewise, expenses are only recorded when incurred. Businesses incur expenses when they receive a service or product.

Under the accrual basis of accounting (or accrual method of accounting), revenues are reported on the income statement when they are earned. When the revenues are earned but cash is not received, the asset accounts receivable will be recorded. (Under the cash basis of accounting, revenues are not reported on the income statement until the cash is received.)

Also under the accrual basis of accounting, expenses are reported on the income statement when they match up with the revenues being reported, or when a cost has no future benefit that can be measured. When an expense occurs and cash has not yet been paid, a liability account will also be recorded. (The expenses that were not paid in the current accounting period will be reported through adjusting entries.)

In other words, under the accrual basis of accounting, the receipt of cash and the payment of cash are not the focus of reporting revenues and expenses. Rather the focus is: 1) what revenues were earned, and 2) what expenses were incurred. Therefore, the accrual basis of accounting provides a more accurate measure of a company’s profitability during an accounting period, and a more accurate picture of a company’s assets and liabilities at the end of an accounting period.

A key advantage of the accrual basis is that it matches revenues with related expenses, so that the complete impact of a business transaction can be seen within a single reporting period.

Auditors will only certify financial statements if they have been prepared using the accrual basis of accounting.

The alternative method for recording accounting transactions is the cash basis.

Example

Pike’s Fish Co. is a retailer that sells outdoor gear like fishing polls and tackle to customers. Pike is working with a large customer, Mike, on a big order in December. Mike wants to purchase $10,000 worth of outdoor supplies to fill his new skiing lodge up north. Since the customer hasn’t fully decided what specific products he wants to purchase, he decides to put a down payment of $5,000 on his order to make sure Pike holds the gear that he knows he does want.

As the end of the year approaches, Mike is still uncertain about finalizing his order. According to the accrual method of accounting, Pike cannot record this as a sale in the current year because he didn’t earn it. No goods or services were exchanged. Mike simply put a down payment on an unfinished ordered.

When Pike receives the $5,000, he would debit cash and credit the unearned revenue liability account. No revenues from this transaction would be reported on the income statement for this year.

Example of Reporting Revenues Under the Accrual Basis of Accounting

Let’s assume that I begin an accounting business in December and during December I provided $10,000 of accounting services. Since I allow clients to pay in 30 days, none of the $10,000 of fees that I earned in December were received in December. Rather, my clients paid the $10,000 in January. Under the accrual basis of accounting my business will report the $10,000 of revenues I earned on the December income statement and will report accounts receivable of $10,000 on the December 31 balance sheet.

Example of Reporting Expenses Under the Accrual Basis of Accounting

Now let’s assume that I paid office rent of $1,500 and incurred $300 of costs for electricity, gas, and sewer/water during December. However, the utilities will not read the meters until January 1, will bill me on January 10 and require that I pay the bill by February 1. Under the accrual basis of accounting I will report the rent expense in December because the rent was used up in December, and I will also report estimated utilities expense of $300 so that the December income statement provides a better measure of December’s profitability. Also the December 31 balance sheet will report a liability such as utilities payable of $300 to communicate a more accurate measure of obligations at December 31.

Comparing Accrual Basis to Cash Basis

Accrual accounting is the opposite of cash accounting, which recognizes transactions only when there is an exchange of cash. Accrual accounting is almost always required for companies that carry inventory or make sales on credit.

The difference between cash and accrual accounting lies in the timing of when sales and purchases are recorded in your accounts. Cash accounting recognizes revenue and expenses only when money changes hands, but accrual accounting recognizes revenue when it’s earned, and expenses when they’re billed (but not paid).

For example, consider a consulting company that provides a $5,000 service to a client on Oct. 30. The client receives the bill for services rendered and makes her cash payment on Nov. 25. The entry of this transaction will be recorded differently under the cash and accrual methods. The revenue generated by the consulting services will only be recognized under the cash method when the money is received by the company. A company that uses the cash accounting method will record $5,000 revenue on Nov. 25.

Accrual accounting, however, says that the cash method isn’t accurate because it is likely, if not certain, that the company will receive the cash at some point in the future because the services have been provided. The accrual method recognizes revenue when the services provided for the client are concluded even though cash isn’t yet in the bank. Revenue will be recognized as earned on Oct. 30. The sale is booked to an account known as accounts receivable, found in the current assets section of the balance sheet.

A company that incurs an expense that it is yet to pay for will recognize the business expense on the day the expense arises. Under the accrual method of accounting, the company receiving goods or services on credit must report the liability no later than the date they were received. The accrued expense will be recorded as an account payable under the current liabilities section of the balance sheet, and also as an expense in the income statement. On the general ledger, when the bill is paid, the accounts payable account is debited and the cash account is credited.

Example of Accrual and Cash Methods

Let’s say you own a business that sells machinery. If you sell $5,000 worth of machinery, under the cash method, that amount is not recorded in the books until the customer hands you the money or you receive the check. Under the accrual method, the $5,000 is recorded as revenue immediately when the sale is made, even if you receive the money a few days or weeks later.

The same principle applies to expenses. If you receive an electric bill for $1,700, under the cash method, the amount is not added to the books until you pay the bill. However, under the accrual method, the $1,700 is recorded as an expense the day you receive the bill.

Summary

  • Accrual accounting is an accounting method where revenue or expenses are recorded when a transaction occurs rather than when payment is received or made.
  • The method follows the matching principle, which says that revenues and expenses should be recognized in the same period.
  • Cash accounting is the other accounting method, which recognizes transactions only when payment is exchanged.

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