Accrual Accounting: Definition & FAQs
Accrual accounting is a method of financial accounting where revenues and expenses are recorded when they are earned or incurred, regardless of when the money changes hands.
Accrual Accounting Explained
Accrual accounting stands in contrast to cash accounting, where transactions are only recorded upon the exchange of cash.
Let’s demystify this a bit more.
Consider a business that provides services in December but doesn’t get paid until January. With accrual accounting, the revenue for this service is recorded in December itself, not when the payment arrives.
This practice ensures a more accurate representation of a company’s financial health because it aligns income and expenses within the same reporting period.
Why is this method critical for businesses? Firstly, it provides a realistic financial picture that aligns revenues with related expenses, making it easier for stakeholders to understand a company’s profitability.
Secondly, accrual accounting satisfies the Generally Accepted Accounting Principles (GAAP), which are the accounting standards used in the United States and adopted by many other countries.
Meeting these principles is a must for publicly traded companies and other larger organizations, who are often mandated to use accrual accounting.
The accrual method is not just for giants; even small and medium-sized enterprises (SMEs) can benefit.
For instance, if you own a local bakery, understanding the accrual method can give you insights into your business cycles and help you with more accurate budgeting.
- Compliance with Standards: Accrual accounting adheres to GAAP, making it a necessity for publicly traded companies and others who need to meet these standards.
- Business Transparency: This method gives a clearer view of your company’s financial health, which is essential for both internal decision-making and external reporting.
- Strategic Planning: Knowing when revenues and expenses occur allows for better budgeting and strategic planning, essential for businesses of all sizes.
An Example Of Accrual Accounting
To implement accrual accounting, one must make use of accounts payable and accounts receivable ledgers. When a service is performed but payment hasn’t been received, the amount is recorded as accounts receivable.
Similarly, if expenses are incurred but not yet paid, they go into accounts payable.
For instance, if you deliver a project in June but get paid in July, you record the revenue in June in accounts receivable.
When July rolls around, you simply shift that amount from accounts receivable to your cash account, aligning your books with reality.
Is accrual accounting difficult to implement?
It can be more complex than cash accounting but offers greater financial insights, making the effort worthwhile.
Can small businesses use accrual accounting?
Absolutely. While initially challenging, the long-term benefits in terms of financial planning and analysis make it a smart choice.
Is accrual accounting required?
For publicly traded companies and some other types of organizations, yes. For smaller businesses, it’s often optional but recommended.