Accrual Accounting
Accrual accounting is one of the accounting method that records revenues and expenses when they are incurred, regardless of when cash is exchanged.
The term accrual actually refers to an individual entry recording system where revenue or expense is recognized in the absence of a cash transaction
Accrual accounting is a method of accounting where revenues and expenses are recorded when they are earned, regardless of when the money is actually received or paid. For example, you would record revenue when a project is complete, rather than when you get paid. This method is more commonly used than the cash method.
The upside is that the accrual basis gives a more realistic idea of income and expenses during a period of time, therefore providing a long-term picture of the business that cash accounting can’t provide.
The downside is that accrual basis doesn’t provide any awareness of cash flow; a business can appear to be very profitable while in reality it has empty bank accounts. Accrual accounting method should be used carefully and in conjunction with the cash-flow statement otherwise the analyst won't be able to make any meaningful insights and it can have potentially devastating consequences on the business
Accrual Accounting: Explained with examples
- Imagine a typical factory having 50 employees. The organization is liable to pay salary to its workers every month. As per the government regulation the company can pay the salary up to the 7th of the subsequent month.
- Now as of 31st of March 2020, the company prepares its financial statements. The worker has basically performed his duty or his activity for the month of March. Now financial statements are prepared on the 31st of March so the company is liable to pay salary to its employees because they have performed their duties for the month of March 2020.
- Suppose the company pay salary to its workers on 7th of April 2020, so the cash is actually flowing out in the next financial year i.e. FY 2021, since FY 2020 ended on 31st of March. However, as per accrual basis we will record the transaction in the P&L statement for FY 2020 under the expenditure column even though transaction will occur in FY 2021.
Let us consider a second example to get a better understanding of the concept
- Supposing on 31st of March 2018, my organization makes a sale for about Rs. 5 lacs and the goods are sold on a 90 day credit
- It implies that I get the money on 2nd June 2019 for the sale that I have made on March 31st. 2018
- Money has not yet come in my account but the goods went out of the factory and also the invoices has been prepared. So, my question is whether I shall enter the sale of Rs. 5 lacs in my P&L statement for FY 2018, since I am receiving the money from the sale of goods in FY 2019?
- As far as accounting goes, we follow accrual that is the ownership has been transferred and the goods have left my factory that is considered as sale irrespective of whether I receive the money or not. So I will record it under the revenue section of my P&L statement for FY 2018.
So, the sale is entered into the books when the invoice is generated rather than when the cash is collected. Likewise, an expense occurs when materials are ordered or when a workday has been logged in by an employee, not when the check is actually written. Similarly taxes on revenue are paid in advance since the profit is shown in the current financial statements.
Accrual Accounting vs Cash Accounting: Key Differences
The key advantage of the cash method is its simplicity—it only accounts for cash paid or received. Tracking the cash flow of a company is also easier with the cash method.
But a disadvantage of the cash method is that it might overstate the health of a company that is cash-rich but has large sums of accounts payables that far exceed the cash on the books and the company's current revenue stream. An investor might conclude the company is making a profit when, in reality, the company is losing money.
Meanwhile, the advantage of the accrual method is that it includes accounts receivables and payables and, as a result, is a more accurate picture of the profitability of a company, particularly in the long term. The reason for this is that the accrual method records all revenues when they are earned and all expenses when they are incurred.
For example, a company might have sales in the current quarter that wouldn't be recorded under the cash method because revenue isn't expected until the following quarter. An investor might conclude the company is unprofitable when, in reality, the company is doing well.
The disadvantage of the accrual method is that it doesn't track cash flow and, as a result, might not account for a company with a major cash shortage in the short term, despite looking profitable in the long term. Another disadvantage of the accrual method is that it can be more complicated to implement since it's necessary to account for items like unearned revenue and prepaid expenses.
| Cash accounting | Accrual accounting |
|---|---|
| Recognizes revenue when cash has been received | Recognizes revenue when it’s earned (eg. when the project is complete) |
| Recognizes expenses when cash has been spent | Recognizes expenses when they’re billed (eg. when you’ve received an invoice) |
| Taxes are not paid on money that hasn’t been received yet | Taxes paid on money that you’re still owed |
| Mostly used by small businesses and sole proprietors with no inventory | Required for businesses with revenue over revenue $ 5 million |
Accrual Accounting: Key Takeaways
- Accrual accounting is an accounting method where revenue or expenses are recorded when a transaction occurs rather than when payment is received or made.
- The method follows the matching principle, which says that revenues and expenses should be recognized in the same period.
- Cash accounting is the other accounting method, which recognizes transactions only when payment is exchanged.
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