Understanding accrual basis accounting
straight to your inbox
Accrual basis accounting provides a more accurate picture of a company's finance operations and health than cash basis accounting. It gives financial statement readers a clearer view of a company's actual profits and capabilities over a period of time. This is achieved by recording revenue when earned and expenses when incurred rather than when cash is received or paid. The method requires recognizing non-cash events, such as receiving products or services on credit, which accrual accounting aims to reflect.
Understanding how accrual basis accounting differs from cash basis accounting is crucial for companies and their stakeholders. By adopting it, businesses can align their financial reporting with actual operations. It allows for more informed financial decision-making and performance analysis.
Generally, businesses that are starting and with simple operations use the cash basis of accounting to do their reporting and their tax filing. Once the business matures, or is required to provide formal financial statements for lending or regulatory reasons, or needs to prepare for its first audit, accrual accounting is used.
Read on as we break down accrual basis accounting and how it impacts companies' financial statements using this method.
What is accrual basis accounting?
Accrual basis accounting is a method of accounting that recognizes transactions and events when they occur, not when payment is made or received. This differs from the cash basis method, which only records transactions when cash changes hands.
Under accrual accounting, revenue is recorded when earned, not when it's received. Expenses are also recorded when incurred rather than when paid. This method provides an appropriate application of the matching principle under the generally accepted accounting principles. Under this principle, revenue and expenses should be recognized (or allocated) during the period that they occur. This ensures a more accurate picture of the company's financial performance and position during an accounting period. It matches revenues to the expenses incurred in earning those revenues.
On the other hand, cash basis accounting, doesn't necessarily match revenues with related expenses, which can distort a company's true profitability from one period to the next. Accrual basis accounting is considered more reliable and mandatory for regulated and public businesses. Generally, the method of accounting used is indicated in the face of the financial statements.
Key components of accrual basis accounting
The accrual method of accounting differs from cash basis accounting in that revenue and expenses are recognized when they are incurred, not necessarily when cash disbursements or cash receipts have taken place. There are two critical components to accrual accounting: deferred revenue and accrued expenses.
Deferred revenue refers to a company's income where the company has received payment but has not provided any services yet. For example, a software company provides an annual subscription for $12,000 - which is paid upfront. The 12,000 are recorded as deferred revenue and represents a liability since the company has the obligation to provide the services and revenue has not been earned yet. During the annual period, at the end of each month, $1,000 will be recognized as revenue.
On the other hand, if the service has been provided and no payment has been received yet, the amount to be paid is recognized as an “Account receivable” or “Customer receivable” or depending on the company, it can be designated as “Accrued revenue”. For example, a landscaping company performs work in December but only invoices the client in January. Though the cash from that job will be received in the new year, the revenue is recognized because the service was offered in the current period.
Accrued expenses represent costs a company has incurred but has not paid for. A typical example is utilities - the usage during the final weeks of the year incurs an expense, even if the invoice from the utility company has yet to arrive. Other typical accrued expenses include accrued payroll, accrued legal services, interest expense, and taxes.
By recognizing expenses in the period they are incurred, the accrual accounting method provides a more accurate picture of a company's finances for that time frame compared to cash basis reporting.
The critical insight of accrual basis accounting is that revenue and expenses are tied to when the economic activity occurs rather than the associated cash flows. Accrued revenue and accrued expenses allow financial statements prepared under the accrual method to more precisely match revenues with the expenses incurred to earn those revenues.
How does accrual accounting work?
Under the accrual basis of accounting, revenues are recorded when sales are made or services are provided, not when payment is received. Similarly, expenses are recorded when costs are incurred, not paid.
On the balance sheet, deferred revenue is categorized as a liability since the company has the obligation to deliver on the goods and services. Accounts receivable (accrued revenues) will appear as assets, since the company has earned the right to these revenues but has yet to receive payment. Accrued expenses are current liabilities since the company has consumed resources or utilized services that will require payment soon, such as accrued wages, taxes, and utilities.
Accrual accounting provides a more accurate picture of a company's net income and financial position at a point in time. This is because it ties revenues to efforts expended to generate them and matches expenses to the periods that benefit from those costs. It allows for better investment and business decisions compared to cash-basis accounting.
Benefits of accrual basis accounting
Accrual basis accounting provides businesses with crucial benefits compared to a cash-only basis. These are some of the advantages of accrual accounting that can be of great help to businesses;
- It provides a more accurate financial picture of a company's performance. By recognizing revenue when earned and expenses when incurred, accrual basis accounting matches revenues to the costs used to generate those revenues.
- It allows for deeper long-term insights into a company's financial health by spreading revenue and expenses over multiple periods. This helps identify trends over time and clear the reporting of any inappropriate lumpiness
- Financial reports are prepared following established accounting standards, providing consistency across companies. Compliance with GAAP/IFRS enhances the reliability and comparability of financial statements.
Examples of accrual accounting
Accrual accounting aims to record accounting transactions at the point in time they occur rather than when payment is made. For example, a manufacturing company accrues an expense of $50,000 on December 15 for supplies that were delivered but still need to be paid for. While the invoice from the supplier is dated December 15, the company only reimburses the invoice on January 15 of the following year. Under accrual accounting, they record the $50,000 expense on their income statement for December, even though payment will only occur in January. This matches the expense with the period when the raw materials were consumed.
Another example is if the company accrues $75,000 in revenue on that same date for goods shipped to customers but for which payment has yet to be received. While revenue is earned in December, payment will be received in mid-January. Accrual accounting requires the company to recognize the $75,000 in revenue on its December income statement. This matches revenue with the period in which it was earned rather than the period in which cash was collected.
Importance of accrual basis accounting in business growth
Accrual basis accounting is essential for businesses seeking growth and progress. It provides:
- More accurate financial reporting reflects a company's financial performance and position over time. This allows for more thoughtful strategic decision-making.
- Insight into a business's profitability by matching revenues to the expenses associated with generating those revenues. This fuels informed decisions about investments, expansions, and innovations.
- A closer alignment of taxable income computation with financial results allows tax planning and liabilities to be forecast more accurately. This promotes steady, sustainable organizational development.
How can accounting software help with accrual accounting?
Modern accounting software streamlines the accrual process through automation. Ramp makes accrual accounting easy by tracking expenses, matching revenues, and integrating spending data from banks and vendors. We automate repetitive tasks and generate customized workflows and reminders to ensure accurate accrual entries each period.
By eliminating manual calculations and adjustments, our accounts payable software provides real-time visibility into accrual impacts on financial reports. This empowered insight fuels informed decision-making for operational teams. Contact Ramp to simplify your accrual process and streamline your business.