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Accrual Basis Accounting Definition
Cash may be important. But, in accounting, accrual basis accounting is the preferred method. Here’s why.
A business has an indeterminate life cycle. At the start, it’s hard to say how long it will last. However, checking its progress means specifying intervals and points of time. So, accounts are usually prepared at practical time intervals, such as a week, month, or year. Having separate accounting periods allow transactions in that period to be isolated, assessed, and compared with transactions from another period. But this creates timing issues: it’s not always clear which accounting period a transaction should be recorded in.
Accrual accounting uses a few principles to navigate these issues:
- First, the revenue recognition principle requires that revenue be recorded in the accounting period in which it is earned, even when no cash has been received.
- Second, the matching principle states that expenses should be recorded in the same accounting period as the revenues they contributed to. Thus, if money spent on advertising boosted sales, the sales and the advertising expense should be reported in the same accounting period, even though the cash from the sales and the payment for the advertising may occur in different accounting periods.
The matching principle is really the central idea of accrual accounting. It avoids the shortcomings of cash basis accounting, under which wide variations in cash receipts or cash payments make it difficult to assess and compare net income.
Accrual Basis Advantages and Disadvantages
- Matches expenses to revenues
- Provides a more accurate picture of financial performance and position
- Shows assets and liabilities not included in cash basis balance sheet
- In accordance with GAAP
- More involved than cash basis accounting
- Liability for income taxes even when no cash has been received
Cash Basis Accounting vs. Accrual Basis Accounting
In cash basis accounting, revenue is recorded only when the cash is received; expenses are recorded only when they are paid. In accrual accounting, transactions are recorded in the accounting periods in which they occurred, even if no cash is involved. Revenues are recognized when earned, and expenses are recognized when incurred.
Since cash basis accounting is restricted to cash transactions, it omits some important non-cash financial transactions, such as accruals and deferrals. Accruals are of two types: revenues earned but not yet received in cash and expenses incurred but not yet paid. Additionally, no inventory is shown in cash basis accounts. GAAP doesn’t allow cash basis accounting because cash basis accounting violates the revenue recognition principle and the matching principle. Nevertheless, the IRS permits businesses with less than $25 million in gross receipts to use cash basis accounting.
When to Use Accrual Basis Accounting
Accrual accounting should be used by businesses with financial transactions that involve deferrals and accruals.
Deferrals occur when there is an advanced exchange of cash. Such early cash transactions can be of both revenue and expenses.
For example, if a customer pays $2,500 before the goods are delivered, the amount is counted as a deferral of revenues and recorded in the unearned revenues account:
|Prepaid Expenses||$ 3,000|
There is no increase in revenues. The unearned revenues account is a balance sheet account. The credit shows the company now has a liability; it owes the customer value to the tune of $2,500.
Again, in June, a company may pay $3,000 for consultancy services in July, August, and September. This transaction would be recorded as:
|Prepaid Expenses||$ 3,000|
Prepaid Expenses is a balance sheet account. The debit shows the company now has an asset worth $3,000, which represents the work the consultant must perform.
Accruals are also of two types: revenue and expense. Accrued revenues are revenues that have been earned but which have not been recorded in the accounts in the normal way; perhaps, services have been performed but not billed.
|Accounts Receivable||$ 1,500|
|Revenues (accrued)||$ 1,500|
Accrued expenses are expenses incurred, which haven’t been paid for. For example, maybe an invoice still has not been received from the vendor or provider.
|Landscaping Services Expense||$ 2,000|
|Accounts Payables||$ 2,000|
Accrual Basis Accounting Frequently Asked Questions
Can you switch from cash to accrual accounting?
The decision to switch from cash to accrual accounting depends, partly, on the needs of external users, such as a bank and the IRS. If the bank has been receiving cash basis reports, it may ask for accounts prepared both ways so it can easily compare the current report to previous reports. For tax purposes, IRS Form 3115 Application for Change in Accounting Method must be filed.
What is an accrual journal entry?
An accrual journal entry is made when revenue or an expense that hasn’t been booked in the regular way is recorded in the accounts. Accrued revenue occurs when services have been performed but not recorded. Accrued expenses are expenses that have been incurred but not booked.
Why are accruals booked?
Accruals are adjustments to the accounts made to ensure revenues and expenses are properly matched. In accrual accounting, when revenues are earned and recorded, all expenses incurred in generating the revenues must also be recorded, regardless of whether cash has been paid or not.
Is accrual a debit or credit?
Accrued revenue is a credit. An accrued expense would be a debit.
Is accrual an asset?
An accrual that records revenue creates an asset.
|Accrued Revenues||$ 1,000|
Is accrued expense an asset?
No. An accrued expense creates a liability.
|Accrued Wages||$ 500|