Accrual accounting means a method of management accounting that enables the enterprise to register revenue before getting paid for goods and services, which are already disposed of. In other words, it is not related to the actual movement of funds.
So, accrual accounting implies that income and expenses should be taken into account in the exact reporting period, when they arose based on the terms of transactions and regardless of the payment time. The cash accounting method, on the other hand, involves income arrangement by the date the funds are received at the cash desk or account, while expenses are considered after their actual payment.
Operating principle of the term
Accrual financial statements inform users not only of past transactions related to the payment and receipt of cash, but also of obligations to deliver financial facilities in the future, as well as cash-equivalent resources that will be also received. Thus, these instruments provide data about previous transactions and events. The information is extremely important for users when making economic decisions.
Consequently, the framework concept of accrual accounting lies in fact that financial events are identified by comparing income and expenses at the interval of transaction performance. It combines current and future cash inflows and outflows. Therefore, the financial standing of a firm tends to be more clear.
Criteria. Accrual accounting is regarded as a standard practice for a majority of enterprises. The exception is provided by micro businesses and private parties. In fact, the Internal Revenue Service (IRS) enables defining small entities to decide on the selected method.
Accrual accounting is applied if the firm’s earnings are lower than the established standard. The condition for implementing this method is the following: the average annual gross receipts for the fiscal period of 3 years doesn’t transcend $27 million.
Advantages of Accrual Accounting
Accounting of business activities using the accrual method is considered a more advanced mechanism. It complies with the requirements of IFRS. In addition, the practice makes it possible to obtain accurate information on the firm’s state at a particular moment with all its liabilities and assets.
Intercomparison of accounting methods
As stated above, there are two major accounting methods, which are used in the financial statements. Notably, both practices can be applied in determining the income tax base.
Under the cash basis, income and expenses are recognized when the associated cash flows occur. This method is convenient to use when the enterprise is small, and the results of its activities are highly dependent on incoming and outgoing monetary flows. Moreover, exchanging cash is anticipated.
In contrast, the accrual accounting determines how income and expenses are allocated by periods. It is important that the rules for recognizing income and expenses are also based on the permanence of the enterprise’s activities (i.e. it is assumed that the firm will exist indefinitely, if there is no evidence to the contrary). Thus, the companies possessing inventory and carrying credit sales are subject to the accrual accounting.
Entities can’t use the cash and accrual accounting methods at the same time. So that it is prohibited to calculate income on a cash basis and expenses on an accrual one. The converse is also true.
Real life examples
The most common cases in study for accrual accounting are given below:
- sale on credit;
- purchase on credit;
- income tax expense;
- rent paid in advance;
- FD interest earned;
- insurance costs;
- electricity costs.
Let’s consider one of the above-mentioned examples. With the accrual accounting method, a transaction is recorded in the ledgers at the time of invoicing, regardless of whether the cash is actually received or not. For instance, a corporation X ltd. made a sale of $500 worth of goods to Y Ltd. Although, the second enterprise hasn’t yet transferred the whole sum of money. Nevertheless, these transactions have been already reflected in the records for the following period.
Division of Accrual Accounts
In fact, there exists a variety of accrual accounts. Prevailing ones consist of accounts payable, bills receivable, business reputation, interests charged, as well as accrued tax obligations.
It’s worth noting that accounts payable are regarded as debts that the enterprise undertakes when obtaining goods and services from the vendor before rendering the actual payment. According to accrual accounting, a liability is shown on the balance sheet acting as an account payable, while the income statement is reflected as an expenditure.