Accrual basis of accounting definition
/What is the Accrual Basis of Accounting?
The accrual basis of accounting is the concept of recording revenues when earned and expenses as incurred. The use of this approach also impacts the balance sheet, where receivables or payables may be recorded even in the absence of an associated cash receipt or cash payment, respectively.
The accrual basis of accounting is advocated under both generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS). Both of these accounting frameworks provide guidance regarding how to account for revenue and expense transactions in the absence of the cash receipts or payments that would trigger the recordation of a transaction under the cash basis of accounting.
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Examples of Accrual Accounting
The accrual basis requires the use of estimates in certain areas. For example, a company should record an expense for estimated bad debts that have not yet been incurred. By doing so, all expenses related to a revenue transaction are recorded at the same time as the revenue, which results in an income statement that fully reflects the results of operations. Similarly, the estimated amounts of product returns, sales allowances, and obsolete inventory may be recorded. These estimates may not be entirely correct, and so can lead to materially inaccurate financial statements. Consequently, a considerable amount of care must be used when estimating accrued expenses.
Accrual Basis Best Practices
When recording transactions using the accrual basis of accounting, be sure to fully document the reason for each adjusting entry made. This is needed so that someone reviewing the reason for the entry in a later period will better comprehend why it was made. This is especially important when the party doing the reviewing is a company’s outside auditor.
Another best practice is to set up adjusting entries to automatically reverse in the following period. This flushes the entries out of the accounting system, which eliminates the risk of discovering stray entries in the accounting records as part of the year-end closing process, and having to reverse them then.
Accrual Basis vs. Cash Basis Accounting
Accrual basis accounting is the standard approach to recording transactions for all larger businesses. This concept differs from the cash basis of accounting, under which revenues are recorded when cash is received, and expenses are recorded when cash is paid. For example, a company operating under the accrual basis of accounting will record a sale as soon as it issues an invoice to a customer, while a cash basis company would instead wait to be paid before it records the sale. Similarly, an accrual basis company will record an expense as incurred, while a cash basis company would instead wait to pay its supplier before recording the expense.
A key difference between the methods is that financial statements produced by a business operating under the cash basis could yield results that are misleading. This is because the firm could delay paying its suppliers until after the reporting period ends, thereby showing a larger cash balance (and greater financial health) than is really the case. This means that someone might conclude that the finances of the organization are robust, when this is not really the case. The reverse situation can also arise, where a company does not record sales because it has not yet received the cash associated with them, resulting in lower reported sales and profits; this gives the impression that the company is doing poorly, when in fact it might be profitable.
Another difference between the methods is that the cash basis of accounting is easier to operate. It requires no accruals, and so can be operated with a reduced knowledge of accounting. Conversely, the accrual basis of accounting requires a reasonable knowledge of accounting principles.
Types of Accrual Accounts
There are several accounts used under the accrual basis of accounting that are not employed under the cash basis of accounting. These accounts include accounts receivable, accounts payable, accrued revenue, and accrued liabilities. Accounts receivable include amounts billed to customers for which payment has not yet been received, while accounts payable are amounted billed by suppliers that have not yet been paid to them. The accrued revenue account contains amounts not yet billed to customers, but which have been earned. The accrued liabilities account contains amounts not yet billed by suppliers, but for which goods have already been delivered or services performed.
Advantages of Accrual Basis Accounting
The accrual basis of accounting tends to provide more even recognition of revenues and expenses over time, and so is considered by investors to be the most valid accounting system for ascertaining the results of operations, financial position, and cash flows of a business. In particular, it supports the matching principle, under which revenues and all related expenses are to be recorded within the same reporting period; by doing so, it should be possible to see the full extent of the profits and losses associated with specific business transactions within a single reporting period. In addition, a business must use the accrual basis of accounting if it wants to have its financial statements audited; an auditors’ opinion on a firm’s financial statements is required by most lenders, so this is a significant issue.
Disadvantages of Accrual Basis of Accounting
A significant failing of the accrual basis of accounting is that it can indicate the presence of profits, even though the associated cash inflows have not yet occurred. The result can be a supposedly profitable entity that is starved for cash, and which may therefore go bankrupt despite its reported level of profitability. Consequently, you should pay attention to the statement of cash flows of a business, which indicates the flows of cash into and out of a business.
When to Avoid the Accrual Basis of Accounting
A small business may elect to avoid using the accrual basis of accounting, since it requires a certain amount of accounting expertise. Also, a small business owner may choose to manipulate the timing of cash inflows and outflows to create a smaller amount of taxable income under the cash basis of accounting, which can result in the deferral of income tax payments.
What is Modified Accrual Accounting?
Modified accrual accounting combines some elements of cash basis and accrual basis accounting. It is intended to show the flows of current financial resources within a government’s financial statements. This approach is promulgated by the Government Accounting Standards Board. There are two primary features to modified accrual accounting. First, revenues are only recognized when they are available and measurable. Revenue availability occurs when the revenue is available to fund current expenditures to be paid within the next 60 days, while it is measurable when the cash flows associated with it can be reasonably estimated. Second, expenditures are only recognized when liabilities have been incurred. This is similar to accrual accounting, except that inventory and prepaid items are immediately recognized as expenditures when they are purchased, and assets are charged to expense when purchased (there is no depreciation expense).
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