Accrual Accounting – What is it and How it Works? | EduBridge India

What is Accrual Accounting?

Accrual Accounting is a financial accounting approach that enables companies to record revenue before receiving payment for goods and services sold, as well as expenses as they are incurred. In other words, under accrual accounting, the company records earned revenue and incurred expenses in its journal regardless of the actual timing of cash transactions.

What is the Accrual Basis of Accounting?

The accrual basis of accounting is endorsed by generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS). These accounting standards offer guidance on how to record revenue and expenses even when there are no cash receipts or payments, which differs from the recordation approach used in cash basis accounting.

How Accrual Accounting Works?

Accrual accounting is based on the principle of recording accounting journal entries when goods or services are provided, rather than when payments are made or received. This method includes entries for debts and payments that are due.

By using this approach, the company combines current and future cash flows to provide a more accurate depiction of its current and long-term financial situation.

Accrual accounting adheres to the matching principle, which requires recording revenues and expenses in the same accounting period.

Both the International Financial Reporting Standard (IFRS) and Generally Accepted Accounting Principles (GAAP) encourage the use of accrual accounting, making it the standard practice for most companies, excluding very small businesses and individuals.

Examples of Accrual Accounting

Accrual accounting involves using estimates in certain situations.

E.g. A company may estimate and record expenses for potential bad debts that haven’t occurred yet. This ensures that all expenses related to a revenue transaction are recorded together, giving a complete picture of the company’s performance in the income statement. Similarly, estimated amounts for product returns, sales allowances and obsolete inventory may also be recorded. However, these estimates may not be entirely accurate and could lead to significant errors in financial statements. Therefore, it is essential to exercise caution and care when estimating accrued expenses.

Accrual Accounting Basis Best Practices

When employing the accrual basis of accounting, it is important to thoroughly document the rationale behind each adjusting entry. This ensures that anyone, including external auditors, who reviews the entry later can understand its purpose clearly. Moreover, a recommended practice is to configure adjusting entries to automatically reverse in the subsequent period. This proactive measure helps eliminate the risk of encountering unneeded entries during the year-end closing process, streamlining the accounting system for more efficient and accurate financial reporting.

Accrual Basis vs. Cash Basis Accounting

Accrual basis accounting stands as the prevailing method for recording transactions in larger businesses, in contrast to the cash basis accounting where revenues and expenses are recorded only when cash is exchanged. For instance, under the accrual basis, a company recognizes a sale upon issuing an invoice to a customer, while a cash basis company waits until payment is received to record the sale. Similarly, an accrual basis company records expenses as they are incurred, whereas a cash-basis company waits until the expenses are paid.

The contrasting methods can lead to potentially misleading financial statements for cash basis companies. By delaying payments to suppliers beyond the reporting period, a cash basis company could appear to possess a larger cash balance and seem financially healthier than it actually is. Conversely, a cash basis company might fail to record sales until cash is received, resulting in lower reported sales and profits, creating a false impression of poor performance when, in reality, the company is profitable.

Moreover, operating on a cash basis is more straightforward, as it requires no accruals and can be managed with limited accounting knowledge. In contrast, the accrual basis demands a solid grasp of accounting principles to accurately record transactions.

In essence, the accrual basis accounting method provides a more comprehensive and accurate representation of a company’s financial health, while the cash basis offers simplicity at the cost of potential distortions in financial reporting.

Types of Accrual Accounts

Under the accrual basis of accounting, several accounts are utilized that are not present in the cash basis of accounting. These accounts encompass accounts receivable, accounts payable, accrued revenue, and accrued liabilities. Accounts receivable pertain to the amounts billed to customers but not yet received as payment, while accounts payable represent the amounts billed by suppliers that are yet to be settled. The accrued revenue account encompasses earnings not yet billed to customers but already earned. On the other hand, the accrued liabilities account involves amounts not yet invoiced by suppliers, but for which goods or services have already been provided.

What are the advantages of Accrual Basis Accounting?

The accrual basis of accounting is favoured by investors as it ensures a more equitable allocation of revenues and expenses over time, making it the most reliable system for assessing a business’s operational outcomes, financial standing, and cash flows. This approach adheres to the matching principle, which dictates that revenues and their corresponding expenses should be recorded in the same reporting period. This enables a comprehensive view of the profits and losses associated with specific business transactions within a single reporting period.

What are the disadvantages of the Accrual Basis of Accounting?

A notable drawback of the accrual basis of accounting is its potential to show profits even when cash inflows have not materialized yet. This can lead to a situation where an entity appears to be profitable on paper but is actually facing cash shortages, possibly leading to bankruptcy despite its reported profitability. Therefore, it is crucial to closely examine the statement of cash flows of a business, as it reveals the actual cash movements into and out of the company.

When to avoid the Accrual Basis of Accounting?

A small business might opt not to adopt the accrual basis of accounting due to the need for specialized accounting knowledge. Additionally, the business owner might intentionally control the timing of cash inflows and outflows to reduce taxable income under the cash basis of accounting, allowing for the postponement of income tax payments.

What is Modified Accrual Accounting?

Modified accrual accounting is a hybrid approach that combines elements of cash-basis and accrual-basis accounting, aiming to display the flow of current financial resources in a government’s financial statements. This method is endorsed by the Government Accounting Standards Board. It involves two main features: Firstly, revenues are only recognized when they are available and measurable. Revenue availability refers to the revenue being ready to fund current expenses within the next 60 days, while measurability means that the associated cash flows can be reasonably estimated. Secondly, expenditures are only recognized when liabilities are incurred, resembling accrual accounting, but with the exception that inventory and prepaid items are immediately recognized as expenditures upon purchase, and assets are expensed without depreciation.

How To learn Accrual Accounting?

Learning accrual accounting can be a valuable skill for understanding financial statements and managing finances effectively. Here are some steps to help you learn accrual accounting:

• Understand the Basics: Start by grasping the fundamental principles of accounting, such as the accounting equation (Assets = Liabilities + Equity) and the concept of debits and credits. Also, familiarize yourself with all the financial statements like the income statement, balance sheet, and cash flow statement.
• Study Accrual Accounting Concepts: Learn the key concepts of accrual accounting, including revenue recognition, expense recognition and the matching principle. Thoroughly understand the difference between cash-basis and accrual-basis accounting.
• Take an Online Course: Look for online courses that cater to beginners and progress to more advanced topics as you become more confident. Check out EduBridge’s accounting and taxation course to kick-start your career.
• Read Accounting Books: There are plenty of accounting books available that explain accrual accounting in detail. Look for books that are geared towards beginners and provide practical examples to reinforce your understanding.
• Practice with Exercises: Practice makes perfect. Look for accounting exercises and problems to solve. Work on sample financial transactions and apply accrual accounting principles to them.
• Use Accounting Software: Explore popular accounting software like QuickBooks or Xero. These tools allow you to record transactions using accrual accounting and generate financial reports, helping you get hands-on experience.
• Seek Online Resources: There are numerous online resources, such as tutorials, videos, and articles, that can help you understand specific accounting concepts and how accrual accounting works.
• Stay Updated: Accounting standards and regulations may change over time. Stay updated with the latest developments in the accounting field by following reputable accounting websites and news sources.

Conclusion

Accrual accounting is a method that records revenues when earned and expenses when incurred, providing a more accurate representation of financial performance. It ensures proper matching of revenues and expenses, offering valuable insights for decision-making. Mastering accrual accounting is crucial for informed financial management and strategic planning. For more details check out our Accounting and Taxation course here.