What is accrual accounting?
The word “cruel,” in its most specific definition, means willfully causing pain or suffering to others. The accrual basis of accounting is considered a complicated accounting method that requires thorough attention to all financial activities (especially cash accounts) when practiced, so much so, that even professional accountants have a hard time taming this complicated accounting beast.
Synonymous terms for cruel are hard, tough, distressing, heartbreaking, and the list goes on – you probably get the point. However, before you feel any more intimidated by accrual accounting, let’s examine what accrual accounting is.
In crystal-clear terms, accrual means the accumulation or increase of something over time, especially payments or benefits. In accounting principles, accrual refers to earned revenues and incurred expenses that significantly impact an income statement of a business over a period.
In the accrual basis of accounting, income is recognized when it is earned, regardless of when the payment is or was received, and expenses are recognized when incurred, irrespective of when they are or were paid out. This method of accounting also recognizes revenue when goods or services were given to a customer.
The expenses related to goods and services are recorded, even when cash has yet to be paid out because there is an expectation that those expenses will be paid in the agreed time.
Similarly, payments are recorded simultaneously, even if they have yet to be received or balance the financial statement.
Accrual accounting is GAAP accepted
Generally accepted accounting principles (GAAP) refers to a set of standards, procedures, and practices that companies, together with their accountants, must comply with when preparing and filing their financial statements.
It is well-known that accrual accounting is accepted under GAAP; as a result, many business entities globally use the accrual accounting approach.
GAAP accepted accrual accounting primarily because accrual accounting entails specific provisions when calculating revenue and expenses.
One significant underlying provision under accrual basis is the matching principle, which plays a pivotal role in producing financial business statements. The matching principle outlines that expenses should match revenue recognition, and both are stimulated together.
What accrual accounting does not account for
Just like cash basis accounting and other accounting principles, accrual basis has its unique setbacks.
The major blow when your method of accounting is accrual is that you can’t keep a clear track of your cash flow. This method is unable to show your business’ ability to generate cash unless your accounting measures include a statement of cash flow.
Accrual accounting is also a rigorous accounting method, as it deals with accounts rather than just cash.
Accrual in cruel comparison against cash basis
In one aspect, cash basis accounting might appear to pale in comparison to accrual accounting when a company states its financial health.
Cash basis has an unfortunate habit of overstating a company’s financial growth by accounting for all of its revenues while, on the flip side, failing to account for its financial obligations and payables.
Ironically, this is what accrual accounting excels at when stating a company’s financial growth. It includes future expenditures and liabilities that will balance with revenues. By doing so, it reflects a more realistic financial health image of the company.
How accrual accounting can be an advantage
When paying your taxes based on your annual income, accrual accounting can be extremely beneficial.
Imagine yourself running a business. Say, in your first year of operation; you earned $50,000 worth of payables and cash combined. As some of that $50,000 is payables, you can’t expect to receive them all on the last day of the year as you file your income statement. But, regardless, you still declare them as your earnings for that particular year. When you pay your taxes, those payables were already taxed, as they were proclaimed as your income for that year even if the money had yet to land in your hands.
Paying taxes for your payables may seem like a chore when you have a low sales record for the year, but it will all look rosier when you earn more, and your taxes are smaller as they were paid in advance. It’s a win-win.
Businesses that accrual basis accounting works best with
While many business entities use the accrual basis of accounting, the most suitable method for your company depends on its business structure, tax-paying scheme, the base of the transaction (cash and/or credit), and income.
If your business has inventory, shareholders, and more significant revenues (a corporation, usually), accrual accounting will work best. Accrual accounting features your payables and receivables in a way that cash basis accounting cannot provide you with.
Since accrual accounting is a structured and detailed approach, it will account for the intangibles of your sales and expenditures, including your assets and liabilities, that cash basis doesn’t typically indicate in financial statements.
Accrual – Not cruel at all
Accrual basis accounting offers companies the opportunity to list cash and credit incomes in the same accounting period that sales occur.
Accrual accounting paints an intricate financial picture of a company’s income, assets, expenditures, and liabilities. While it can help increase the operational efficiency of your business, it can also trigger certain risks that must be addressed through an in-depth analysis of the approach.
By paying careful attention to cash flow, accrual accounting can be considered as a more financially accurate accounting method than many other systems. And it can also give companies a strong financial standing, which could well open the doors of opportunity and attract potential investors.