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Accrual accounting is a method of recording revenues and expenses based on when they are earned or incurred, rather than when cash is exchanged.Â
This method follows the matching principle, which states that revenues and expenses should be recognized in the same period. Companies that carry inventory or conduct credit-based transactions, or that have annual revenues that average more than $25 million over a three-year period, must use accrual accounting.
Accrual accounting allows a company to measure its financial performance more accurately, as it reflects the economic events that occur in a given period, regardless of the timing of cash flows. For instance, if a business sells a customer certain goods or services one month but does not get paid until the next month, accrual accounting would record the income in the month of sale rather than the month of payment. In a similar manner, accrual accounting would record an expense in the month of occurrence rather than the month of payment if a corporation incurred it one month but did not pay it until the next month.
Accrual accounting allows a company to measure its financial performance more accurately, as it reflects the economic events that occur in a given period, regardless of the timing of cash flows. For instance, if a business sells a customer certain goods or services one month but does not get paid until the next month, accrual accounting would record the income in the month of sale rather than the month of payment. In a similar manner, accrual accounting would record an expense in the month of occurrence rather than the month of payment if a corporation incurred it one month but did not pay it until the next month.
Under accrual accounting, journal entries are adjusted at the conclusion of each accounting period to reflect revenues and expenses that have already been received or spent but not yet reported. Both the income statement and the balance sheet are impacted by these adjustments, known as accruals. Both accumulated revenues and accrued expenses fall under the category of accruals.
Revenues that have been earned but not yet received or reported are referred to as accrued revenues. For instance, if a business offers a service to a client on credit, accruing income and accounts receivable would be listed on the balance sheet. The customer's debt is represented by the accounts receivable, while the growth in revenue is shown by the accrued revenue. When the client pays, the business would have more cash on hand and fewer accounts receivable, but income would remain unaffected.
Accrued expenses are expenses that have been incurred but not yet paid or recorded. For instance, if a business relies on electricity to run its operations, an incurred expense and accounts payable would be listed on the balance sheet. The amount owed to the electricity provider is represented in the accounts payable, while the increase in expense is represented by the accrued expense. When the business pays its power bill, it will lower its cash and accounts payable, but expenses won't change.
Because it presents a more accurate and thorough view of a company's financial status and performance than cash accounting, accrual accounting is extensively utilized and accepted by accounting standards like GAAP and IFRS. Cash accounting only records transactions when money is transferred, which can result in inaccurate or lacking information on a company's revenues, costs, assets, and liabilities. However, accrual accounting also has some limitations and challenges, such as:
- Compared to cash accounting, it necessitates more complicated and frequent changes.
- Compared to cash accounting, it calls for more estimations and judgment calls.
- It might not accurately depict a company's actual cash flow position.
- Due to scheduling discrepancies, it could result in accounting mismatches between revenues and expenses.
