The accrual basis or accrual method is an accounting approach wherein income and expense items are recorded in the books of accounts as they are earned or incurred, regardless of when the actual cash transactions take place. This method ensures that financial statements provide a more accurate representation of a company’s financial position.
History and Development
Historical Context
The accrual method of accounting has its roots in the necessity for businesses to present a more accurate financial position to stakeholders. It evolved as businesses grew and the need for a more reliable financial reporting system became paramount.
Legislative Framework
In various jurisdictions, the use of the accrual basis is mandated for certain types of taxpayers, particularly those maintaining inventories. This ensures consistency and reliability in financial reporting and taxation.
Principles of Accrual Accounting
Revenue Recognition Principle
Under the accrual basis, revenue is recognized when it is earned and realizable, not necessarily when cash is received. This aligns income with the period in which the corresponding revenues are generated.
Matching Principle
Expenses are recorded when they are incurred, matching them with the revenues they help generate during the same accounting period. This principle ensures that all costs are documented in the same period as the related income, improving the accuracy of financial statements.
Types of Transactions
Revenue Transactions
Revenue is recorded at the time of earning, may it be sales of goods or services rendered, even before payment is received from the customer.
Expense Transactions
Expenses are documented when incurred, irrespective of actual cash payments, which includes salaries, utilities, and rent.
Examples and Applications
Business Scenario
In a manufacturing business, the accrual method will record expenses when raw materials are received and not when they are paid for, and it will record revenue when products are shipped to customers, not necessarily when the payment is received.
Exceptions
Exceptions include:
- Bad Debts: Recognized when it is evident that the debt will not be collected.
- Advance Payments: Payments received for services or merchandise to be delivered in the future.
Comparisons with Cash Basis Accounting
Definition
- Accrual Basis: Records revenues and expenses when earned or incurred.
- Cash Basis: Records revenues and expenses only when cash is exchanged.
Applicability
While small businesses might prefer the cash basis for its simplicity, larger enterprises are usually required to use the accrual method for a more accurate financial depiction.
Advantages and Disadvantages
Advantages
- Accurate Financial Position: Presents a true picture of financial health.
- Better Matching of Revenues and Expenses: Improved financial reporting.
Disadvantages
- Complexity: More challenging to implement.
- Non-Cash Transactions: Inclusion complicates cash flow management.
Related Terms
- Cash Basis: An accounting method where revenues and expenses are recorded only when cash is received or paid.
- Deferred Revenue: Money received for goods or services which have not yet been delivered or performed.
- Accrued Expense: An expense that has been incurred but not yet paid.
FAQs
Why must companies with inventories use the accrual method?
Can small businesses use the accrual basis?
Summary
The accrual basis accounting method is essential for businesses seeking to accurately reflect their financial position by recognizing revenues and expenses when they are earned or incurred. This method provides a realistic view of a business’s profitability and financial health, despite its complexity compared to the cash basis accounting method.
References
- GAAP (Generally Accepted Accounting Principles)
- International Financial Reporting Standards (IFRS)
- IRS Publication 538 (For US taxation)
The accrual basis of accounting ensures comprehensive financial reporting, fostering better business decisions and transparency for stakeholders.
