According to the accrual basis of accounting, income and expenses are recorded as soon as transactions occur. This process runs counter to the cash basis of accounting, where transactions are reported only when cash changes hands. Generally speaking, the accrual accounting method is considered the superior approach for companies looking for more accurate profitability metrics in their income statements. For this reason, most companies employ accrual (or accrual) accounting as their default accounting practice, although it is arguably more complicated and subjective than cash accounting.
- Businesses use the accrual (or accrual) method of accounting to record income and expenses at the time transactions occur, even if the money changes hands at a later date.
- Accrual (or accrual) accounting is different from cash accounting, where businesses only record transactions once payments are made and settled.
- The accrual method of accounting is favored by companies seeking more accurate measures of their profits and expenses.
Understanding accrual accounting
Most companies offer delayed accounts payable and accounts receivable programs, allowing loyal customers to enjoy goods and services now and pay later. This flexibility helps stimulate continuous income streams that positively impact a company’s long-term bottom line, even if cash is not received immediately. For example, a furniture store that uses the accrual accounting method may sell a sofa to a customer on credit and immediately record the sale on its books, long before the customer finally pays the purchase invoice.
Accrual accounting and matching principle
One of the most important concepts of the accrual (or accrual) accounting method is the principle of agreement, which states that the income generated must be matched with the related expenses, within the same reporting period in which the gains were obtained, in an effort to eliminate confusion. This principle, as dictated by generally accepted accounting principles (GAAP), applies to both the sale of goods and the provision of services. Without the principle of correspondence, financial statements would disclose little useful information because readers would not obtain a holistic assessment of assets and liabilities.
The principle of equalization refers to employee commissions, staff bonuses, and any other payments that may be made during a period of time other than that made at the time of sale. Consider a jewelry boutique, where in February, an employee sells a $ 20,000 neckless diamond to a customer on credit. Suppose the employee is entitled to collect a 10% commission on the sale, which the customer finally pays in April. According to accrual accounting rules, the boutique must record the outgoing commission payment of $ 2,000 to the employee on its February expense reports, although the employee will not pocket the money until two months later.
Disadvantages of the accrual accounting method
While the accrual method presents a more accurate picture of a company’s financial profile, this process can make it difficult for companies to accurately track how much cash they actually have on hand. Failure to carefully monitor cash flows autonomously from your accrual (or accrual) accounting practices can lead companies to overextended financial situations.
For most accounting programs, such as QuickBooks, the default setting for all financial reports is the accrual accounting method.