Accrual Accounting Methodology
Accrual accounting is the preferred approach for companies reporting their financial statements under generally accepted accounting practices (GAAP), which are issued through the standards of theFinancial Accounting Standards Board(FASB).
Accrual accounting requires companies to record sales at the time in which they occur. Unlike the cash basis method, the timing of actual payments is not important. If a company sells an item to a customer through a credit account, where payment is delayed for a short term (less than a year) or long term (more than a year), the accrual method records the revenue at the point of sale.
This can be important for showing investors the sales revenue the company is generating, the sales trends of the company, and the pro-forma estimates for sales expectations. In contrast, if cash accounting was used, a transaction would not be recorded for a while after the item leaves inventory. Investors would then be left in the dark as to the actual sales performance and total inventory on hand.
Key Takeaways
- There are two accounting methods practiced by companies: the accrual accounting method and the cash accounting method.
- Only the accrual accounting method is allowed by generally accepted accounting principles (GAAP).
- Accrual accounting recognizes costs and expenses when they occur rather than when actual cash is exchanged.
- The matching principle of accrual accounting requires that companies match expenses with revenue recognition, recording both at the same time.
- Only public companies are required to use the accrual accounting method.
GAAP
GAAP includes certain revenue recognition standards that companies must follow. GAAP includes certain revenue recognition standards that companies must follow to ensure that revenue is recognized when a sale has been transacted, regardless of when the customer pays. If goods are transferred to the customer, or services are provided, then revenue is recognized. If the customer has not paid, then a corresponding accounts receivable is booked, which is eliminated once the company receives cash.
However, companies still have a great deal of flexibility to enact accounts receivable procedures with varying time frames.
Accrual accounting is another term for the matching principle. This requires that companies match revenues with the expenses incurred to generate them.
A key example of the matching principle is depreciation. Let's say that a company pays for items of property, plant, and equipment in cash, it will record a reduction in cash and an increase in long-term assets, and no expense is recorded.
Depreciation allows a company to recognize that this purchase is an expense; the asset will wear up over its useful life and will need to be replaced. Since the asset will be generating additional revenue during its useful life, the company should take the cost of the asset and spread this over the useful life to match the revenue it has generated.
GAAP is required for public company accounts that are filed with the Securities and Exchange Commission(SEC). Non-listed companies may choose to follow GAAP if they require financing or if their accounts are scrutinized by a third party, for example, they are required to be audited. In any case, it is commonplace to use accrual accounting. Smaller enterprises may choose to use cash accounting as their accounts are not used externally or by third parties.
Accrual accounting highlights the fact that some cash payments for goods or services may never be received from a consumer.
The Bottom Line
Companies can use the accrual accounting method or the cash method when preparing their financial statements; however, if a company is public, it must use the accrual accounting method as specified by GAAP. A company might also use the modified cash-basis accounting for its internal records.
GAAP prefers the accrual accounting method because it records sales at the time they occur, which provides a clearer insight into a company's performance and actual sales trends as opposed to just when payment is received.
FAQs
GAAP prefers the accrual accounting method because it records sales at the time they occur, which provides a clearer insight into a company's performance and actual sales trends as opposed to just when payment is received. Investopedia requires writers to use primary sources to support their work.
Why GAAP requires the accrual basis of accounting rather than the cash basis of accounting? ›
Generally accepted accounting principles, or GAAP, require accrual accounting because it presents a more accurate picture of a company's financial condition.
Why an organization would use accrual basis accounting instead of cash basis accounting? ›
Benefits of accrual accounting
- You have a much more accurate picture of business performance and finances.
- You can make financial decisions with far more confidence.
- It can sometimes be easier to pitch for long-term finance.
One reason for the accrual method's popularity is that it smooths out earnings over time since it accounts for all revenues and expenses as they're generated. The cash basis method records these only when cash changes hands and can present more frequently changing views of profitability.
Why do companies like Walmart use accrual basis accounting rather than cash basis accounting? ›
Accrual basis accounting applies the matching principle - matching revenue with expenses in the time period in which the revenue was earned and the expenses actually occurred. This is more complex than cash basis accounting but provides a significantly better view of what is going on in your company.
Why is accounting done on accrual basis? ›
The performance of a business is assessed more accurately due to the application of the accrual concept. This is because accruals are portrayed in financial statements that indicate the financial health of the company. This happens due to the availability of information on accounts payable and receivable.
Why not use cash basis accounting? ›
Cash accounting does a good job of tracking cashflow but does a poor job of matching revenues earned with money laid out for expenses. Simple cash accounts will not give a true picture of the business performance. In order to offer credit and loans, banks might require accounts to be prepared under GAAP.
Why is the accrual basis of accounting most useful? ›
Accrual basis accounting is one of two leading accounting methods and the preferred bookkeeping method for providing an accurate financial picture of a company's business operations. Accrual basis accounting recognizes business revenue and matching expenses when they are generated—not when money actually changes hands.
Why do most companies use the accrual basis? ›
It Simplifies Strategic Planning
As a result, accrual accounting allows you to better plan ahead to prevent crises as a result of unforeseen shortages and to be prepared to make the most of upcoming windfalls.
Why might a business prefer to use the accrual method instead of the cash method to record revenue and expenses? ›
Accrual basis accounting records income and expenses when they're incurred, regardless of whether money has been exchanged yet. Accrual basis accounting is typically best because it offers the most accurate information about your business's performance.
Cash-basis accounting documents earnings when you receive them and expenses when you pay them. However, the accrual method accounts for earnings the moment they are owed to you and expenses the moment you owe them; it does not matter when your money enters or leaves your account.
Why switch from cash to accrual accounting? ›
Accrual accounting, on the other hand, records revenues and expenses when they are earned or incurred, regardless of when the cash transaction occurs. This method provides a more accurate picture of a company's financial health because it matches related revenues and expenses in the same period.
Why is the accrual basis of accounting generally preferred over the cash basis quizlet? ›
The accrual basis of accounting is preferred over the cash basis of accounting because it reflects a better association of revenues and expenses with the appropriate accounting period. The accrual basis of accounting recognizes all resource changes when they occur.
Why does GAAP require accrual accounting? ›
GAAP prefers the accrual accounting method because it records sales at the time they occur, which provides a clearer insight into a company's performance and actual sales trends as opposed to just when payment is received. Investopedia requires writers to use primary sources to support their work.
Why use accrual vs cash? ›
The difference between cash and accrual accounting lies in the timing of when sales and purchases are recorded in your accounts. Cash accounting recognizes revenue and expenses only when money changes hands, but accrual accounting recognizes revenue when it's earned, and expenses when they're billed (but not paid).
What are the disadvantages of cash basis of accounting? ›
Disadvantages of Cash Basis of Accounting
1. It provides a less accurate picture of the financial position of the business as compared to the accrual basis of accounting. 2. Business data can be manipulated by deferring payments or late deposit of cheques.
Why is the accrual basis of accounting a better practice generally than the cash basis of accounting? ›
The cash-basis approach is easy to use, but it often fails to provide a complete picture of a business's finances. Meanwhile, the accrual method requires a more thorough approach that makes it easy to form a complete financial picture of your company and its current health.
What GAAP concept is satisfied by using the accrual basis of accounting? ›
Accrual accounting follows the matching principle, which states that revenues and expenses should be recorded in the same period. Accrual accounting is encouraged by International Financial Reporting Standards(IFRS) and Generally Accepted Accounting Principles (GAAP).
What basis of accounting does GAAP require on the income statement? ›
GAAP requires companies to follow accrual accounting, which means that revenues and expenses are recognized when they are earned or incurred, regardless of when the cash is actually received or paid out.
