What Is the Purpose of Accrual Accounting?
There are two methods of accounting: cash and accrual. In cash accounting, transactions are recorded when payment occurs. In the accrual method, revenues and expenses are matched and recorded at the time the good is delivered or the service is performed, regardless of when cash actually changes hands. Although cash accounting may be easier to do, accrual accounting gives a much more accurate view of a company’s financial position at a given time and its future prospects. Companies and businesses may be federally required to use accrual accounting based on their industry and/or based on their size as measured by revenue thresholds, and many others choose to use it because of the enhanced information it provides.
What is the Purpose of Accrual Accounting?
Accrual accounting gives a more accurate, real-time view of a company’s finances. Many financial transactions are completed through credit or invoicing at a later date. With accrual accounting, these future payments (made or received) are recorded when the service happens or the good is delivered. By recognizing revenue and expenses in the proper period and not when money actually changes hands, stakeholders receive an overall picture of financial health that allows business owners and investors to make good financial decisions.
This helps provide:
- An accurate picture of how much the company both spent and owes versus the amount actually earned during a given accounting period.
- A clear evaluation of the company’s overall financial position and direction.
- Insights into the results of operational and organizational changes.
- More accurate information for forecasting and planning the future.
What Are the Differences Between Accrual and Cash Accounting?
Cash accounting recognizes transactions at the time when money exchanges hands. For instance, if a customer is billed for a purchase in September and pays the bill a month later, the revenue is recorded when the payment is received in October. If the company buys office supplies on credit and pays for them later, the expense is recognized only when the bill is actually paid. Wages paid to an employee are only recorded as an expense when the check is issued. Cash accounting focuses primarily on how much cash the business has on hand at any given time.
Accrual accounting, on the other hand, takes into account the company’s future revenues and expenditures. A customer purchase is recorded as revenue on the date the service is performed or good is delivered. Whether the customer pay immediately (Cash) or purchases on credit (Accounts Receivable), Income is recorded. Likewise, money spent by the company is recorded on the service date regardless of whether the purchase is made with cash or credit.Accrual accounting gives a more complete and accurate depiction of the company’s financial status.
Small businesses (defined by the IRS as those with less than $26 million in annual revenue) that do not carry inventory or make credit sales may generally choose whether to use cash or accrual accounting. Larger companies are generally required to use the accrual method. Many business owners assume cash accounting is easier and less resource-consuming process, but accrual accounting can generally be implemented with sufficient training and process documentation.
What Does Accrual Mean?
Accrual is the recording of revenue that a business has earned but for which it has not yet received payment, or expenses that the business has incurred but has not yet paid. This concept may be extended to include non-cash assets, pre-payments, or other transactions that are carried out over a period of time.
Many businesses pay their expenses with corporate credit cards or other means of delayed payment. Likewise, many businesses offer credit terms to their customers. Therefore, a simple cash-based balance sheet cannot provide these companies the reliable information they need to manage their resources and plan future projects.
Accrual accounting matches expenses and revenues to the time periods in which they are incurred. This allows companies to better monitor their cash flow and to identify and remedy potential profitability issues.
Examples of Accruals
Suppose your company sells construction supplies. A builder purchases $10,000 worth of your drywall panels on a net-30 invoice. On the date of the sale, you record $10,000 of revenue. At the same time, you increase Accounts Receivable by $10,000. The customer pays the invoice three weeks later. On that date, you increase Cash by $10,000 and decrease Accounts Receivable by $10,000.
Let’s say that during the interim between the sale and the payment, your company desires to make a large purchase but is a little short on cash. Accrual accounting can help you determine when sufficient funds will become available, what financial effect the purchase is likely to have on your business, and what terms to negotiate with the supplier.
As another example, suppose your company provides computer software services. In order to meet rising demand, you purchase a new $15,000 server on credit. On the date of the purchase, you increase Accounts Payable by $15,000 on the balance sheet. You also record a $15,000 expense on the income statement. Accrual accounting lets you know that even though your company may have cash on hand at the moment, there is an upcoming payment that must be taken into consideration.
Other common examples of accruals include:
- Utility bills
- Income taxes
- Interest payments received
- Advance rent payments
- Post-sales discounts
- Audit fees
Principles of Accrual Accounting
Accrual accounting includes the recording of revenue that has been earned but for which payment has not yet been received, as well as expenses that the company has incurred but has not yet paid. By recording income and expenses in the same accounting period regardless of when money actually changes hands, accrual accounting gives an accurate view of the company’s financial position.
Accrual accounting uses what is called the “matching principle.” This means that revenues are matched to expenses at the time of a transaction. Real-time cash flow (such as over-the-counter cash sales) is combined with anticipated future cash flow (such as credit sales) to provide more accurate financial information than could be obtained through simple cash accounting.
Accrual accounting may also include prepaid expenses. Examples of this are rent paid in advance, annual software subscriptons or utilities such as Internet services that are paid at the beginning of a month before the services are actually used.
Does your company need help implementing accrual accounting, or would you like more information about how this process will specifically benefit your business? Reach out today for a free consultation from our expert CFOs.
About the Author
A veteran of the financial services industry, Kyle has served as CFO, COO, and Senior Auditor for organizations such as Arthur Andersen, LLP and CSI Capital Management, Inc. He has also served as the CFO for the general partners of Athlon Venture Fund I, LP and Dawson Real Estate Fund, LP.
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