What is accrual basis accounting
Accrual basis accounting definition
Accrual basis accounting is a method of accounting where income is recognised when earned and expenses are recognised when incurred, regardless of when the cash is received or paid. This method of accounting is based on the matching principle, which states that expenses should be matched with the revenue they help generate in the same accounting period. Accrual basis accounting provides a more accurate picture of a company's financial position and performance than cash basis accounting, as it reflects the company's financial activities more accurately.
To clarify further, accrual basis accounting records revenue when it's earned, such as when a sale is made or a service is performed, even if the payment is not yet received. Likewise, expenses are recorded when they are incurred, regardless of whether payment has been made or not. For example, if a business purchases inventory on credit in one month, the expense is recorded in that month, even if the payment for the inventory isn't made until the following month.
This method of accounting provides a more accurate reflection of a company's financial position and performance because it allows for a better matching of revenue and expenses. By recording revenue and expenses when they are earned/incurred, it takes into account business activities that have occurred, but are yet to be paid/received, which is more representative of the true financial position of the business.
It's important to note that accrual basis accounting can be more complex than cash basis accounting, as it requires ongoing tracking of accounts payable and receivable, as well as the maintenance of accurate records of revenue and expenses. Additionally, not all businesses are required to use accrual basis accounting; some small businesses may elect to use cash basis accounting instead, which is simpler and more straightforward.
Here are some additional points to note about accrual basis accounting:
- Accrual basis accounting is the required method of accounting for companies that have over $25 million in annual gross receipts, per the Internal Revenue Service (IRS).
- One advantage of accrual basis accounting is that it provides a more accurate picture of a company's financial health over time as it accounts for revenue and expenses as they are earned/incurred, rather than just when cash changes hands.
- A potential downside of accrual basis accounting is that it can be more difficult to understand for people who are not familiar with accounting principles, compared to cash basis accounting which simply tracks cash in and out.
- Accrual basis accounting is often used by larger businesses, public companies, and companies that sell on credit terms, as it provides better insights into their financial performance.
- In addition to recording revenue and expenses, accrual basis accounting may also involve adjusting entries for things like accrued interest, depreciation, and bad debts. These adjustments are made to ensure that the financial statements accurately reflect the company's financial position.
- An important feature of accrual basis accounting is the use of "accounts payable" and "accounts receivable" transactions, which track what is owed to/from a company. This helps to ensure that bills are paid on time and that income is received in a timely manner.
