Whatever the business you are in, for instance, retailing widgets, delivering office or home vacuuming services, nursing to pets, even manufacturing engineering apparatus, your business functions under some rudimentary principles of contemporary accounting. Such principles are largely accepted and known practices of accounting. These elementary principles make the base of modern accounting practices.
What is the Accrual Basis of Accounting?
Accrual accounting represents the concept of recording revenues where revenue or expenses are recorded when a transaction occurs rather than when payment is received or made. The main principle in the Accrual Basis of Accounting is that revenues and expenses should be recognized in the same period.
The Revenue or income Principle In the Accrual Basis of Accounting
The revenue principle states a point when bookkeepers can report a transaction as revenue on the books, and this states that income from the business has been earned and reported at the point of sale. This means that the income occurs when the purchaser takes legal ownership of the goods or services sold or performed, not when the seller accepts cash or price for the transaction. This concept is sometimes known as the “revenue or income recognition principle.”
The Expense Principle In the Accrual Basis of Accounting
The expense principle describes when the book-keeper is required to record the transaction as an expense in the books. The expense recognition principle defines that an expense occurs only when the business accepts goods or services from another party. Principally, it means the expenses occur only when the goods are received, or the services are performed, irrespective of when the business is invoiced or pays for the transaction.
Generally, businesses use one of the two basic accounting methods in their bookkeeping system for recording business transactions; one is a cash basis, and the other is an accrual basis. Although most organizations use the accrual basis, which is considered the most suitable method but for your business, it depends on the sales volume, whether or not you trade on a credit basis and your business structure.
What is accrual vs. cash accounting?
What is the difference between cash and accrual accounting?
The difference between cash and accrual accounting is that revenue and expenses are recognized and recorded when they occur in accrual accounting. On a cash basis, accounting revenue is reported on the income statement only when cash is received. Publicly-traded companies use the accrual method more often than cash because this method smooths out earnings over time.
The cash method is known as a simple method, and in the cash method, the books are managed based on the actual cash flow in and out of business. Whereas the income is recorded or noted when real cash is received, and expenses are recorded when cash is actually paid.
In a sole proprietorship, the owners and businesses with no inventory use the cash method. Where tax is concerned, it is occasionally advantageous for new start-ups to employ the cash method of accounting. The recording of income can be deferred through this method until the next tax year, though the expenses are reported immediately.
This accounting method records expenses and revenues or income when they get incurred, regardless of when cash is exchanged. The term “accrual” mentions any single entry recording, either revenue or expense, in the absence of a cash transaction.
In more simple words!
Accrual accounting is an accounting method where revenues or expenses are recorded in the books when a transaction occurs rather than when payment is made or cash received. For instance, you would record an entry of revenue when a project gets completed instead of receiving payment. Usually, this method is more frequently used than the cash method. An accounting basis in which organizations record, at the time when the events get occurred, transactions that change an organization’s financial statements, even if payment (cash) is not exchanged yet. Expenses incurred but not yet paid in cash.
Accrual Basis of Accounting Example
Expense: When a company receives a utility bill (electricity consumed) in July for a past period (June of the previous year), this will be recorded as an expense accrual.
Revenue: When the organization has delivered goods or services, payment (cash) has not been received.
Accrual Basis of Accounting Classifications!
There are several dissimilar types of accruals. The commonly used are future tax liabilities, goodwill, accounts receivable (like the revenue in our example above), future interest expenses, and accounts payable. All accounts payable are essentially a type of accrual, but not all accruals are accounts payable. An accrual accounting method is preferred and the desired method because it affords a more complete and comprehensive reporting of the business’s assets, stockholders’ equity, and liabilities at the end of an accounting period. There are two main principles or concepts, the revenue recognition principle and the matching principle, the accrual basis of accounting uses.
Reasons for accrual accounting
The accrual accounting method permits the business owner to look at a glance if the business is profitable or money-making, where the profit is coming, and where expenses are paid. Accrual accounting also matches expenses with the revenues the business has incurred to produce them. Accrual Basis of Account is preferred over Cash basis because it imitates a better and clear association of expenses and revenues with the applicable accounting period. The accrual basis of accounting identifies all resource changes when they get occurred.
Cash basis or Accrual basis or both?
Although the accrual basis of accounting offers a superior long-term assessment of your business finances, whereas the cash method provides you a better picture of the funds (cash) in your bank business account, this is since the accrual accounting method accounts for cash that’s yet to be received. The tax code permits a business organization to compute and calculate its taxable income using a cash or accrual basis, but it cannot use both accrual and cash. The accounting standards require all businesses to be operated on an accrual basis where financial reporting purposes are concerned.
If you are intended to convert to accrual, then subtract cash payments pertinent to the last accounting period. By shifting these cash payments to the previous period, you decrease the current period’s beginning retained earnings. Cash receipts collected during the current period might require to be deducted.
The accrual basis accounting method is ordinarily accepted and used as the most systematic and precise method of managing accounts. It does not mean that banks don’t consider the accrual method at all.
An accrual, a debit, or credit!
How to calculate the accrual basis of accounting you can watch in the video below:
Usually, an accrued expense journal entries are taken as a debit to an expense account. The debit entries increase your expenses. You also apply a credit to an accrued liabilities account, and your expenses increase on the income statement. An accrual is considered an expense that has been documented in the current period for which a merchant’s invoice (bill) has not been received yet, or revenue that has not been billed so far. Hence, when the expense is accrued, it falls under the balance sheet’s current liabilities section.
Advantages and disadvantages of cash basis and accrual basis accounting!
Accrual accounting has numerous advantages and benefits; many of them are associated with correcting and comprehensive income and expense reporting: It delivers an accurate representation of the business’s overall cash flow. Several business transactions occur over a period of numerous months and, therefore, several accounting periods.
Largely, cash-basis businesses record income when it’s received and subtract expenses when they truly get paid. Whereas, on accrual basis businesses, take income into account when it’s earned and abstract expenses when they’re incurred, irrespective of the timing of cash (money) receipts or payments. The accrual basis accounting method’s key advantage is that it offers a more precise depiction of how the business the performance is over the long-term over the cash method. The disadvantages are, it is more complex and difficult than the cash basis, and income taxes might be owing on revenue before payment (cash) is truly received.
Disadvantages of Accrual Accounting
Accrual basis accounting is a supplementary complex that needs more resources and time, but you know most small business owners don’t have much time. It includes the trailing of cash flows, accounts payables, and accounts receivables. It might tilt the short-term financial views of your business too.
With this accrual method, revenues and expenses are reported at the time to occur, irrespective of cash has actually changed hands or not. An exceptional example is the sale of goods or services on credit. The sale figure is reported into the books when the invoice gets created rather than when the cash (money) is received. Similarly, expenses occur when raw materials are ordered to the suppliers or when a work-day has been logged in by the staff, not when the check is actually issued. The disadvantage of this method is, you are required to pay income taxes on income before you’ve actually collated it.
CONCLUSION
The cash method seems to be suitable for small-sized, cash-based businesses or small service providing company. It’s better to consult your accountant or business attorney before deciding on your business’s accounting method.
After leaving Wells Fargo Bank in 2014, Daniel began a career as a finance consultant, advising companies and individuals on economic policy, labor relations, and financial management.
At Nimblefreelancer.com, Daniel writes about personal finance topics, value estimation, budgeting strategies, retirement planning, and portfolio diversification.
Read more on Daniel Smith's biography page.
Contact Daniel: daniel@nimblefreelancer.com
