What is Accrual in Accounting?Definition, Entries, Basis, Examples & More!
What Is Accrual Accounting?
Businesses will generally choose one of the two common accounting methods for keeping their books.
Accrual accounting is one of these methods, and it is the method that most companies use.
With accrual accounting, income and expenses are recognized by the company when transactions occur, whether or not the cash is actually received.
In accrual accounting, revenue and expenses are recognized in the same period in order to follow the matching principle.
The matching principle requires businesses to recognize revenues and expenses that are related in the same period.
This is required by the Generally Accepted Accounting Principles (GAAP), which public companies in the United States must follow.
The other method of accounting is cash accounting.
This method recognizes transactions when a payment is received and is more commonly used by sole proprietorships and small businesses.
How To Use Accrual Accounting
Since accrual accounting follows the matching principle by recording revenues and expenses when they occur, these inflows and outflows of cash can be combined with revenues and expenses that are expected in the future to allow a better understanding of a company’s current finances.
Most companies do use accrual accounting, although some small businesses and sole proprietorships use cash accounting.
The IRS allows small businesses to choose their method of accounting unless they have earned an average of 25 million in annual gross receipts for the last three tax years, in which case they are required to use the accrual method of accounting.
The accrual method of accounting does give more accurate information about a business’s financial position, but it is also more difficult and expensive to use.
Accrual accounting was developed due to increasingly complex business transactions and because of a desire to provide companies and investors with more accurate financial information.
The financial situation of companies is often affected by long-term projects that provide cashflows or by selling on credit.
So, this should be apparent in a company’s financial statements, and accrual accounting allows this.
Businesses can immediately see the effects of expected revenues and expenses with accrual accounting, thus allowing them to better manage their current situation as well as make plans for the future of their business.
Advantages of Accrual Accounting
Accrual accounting is generally required for businesses that make credit sales or carry inventory.
Accrual accounting recognizes financial transactions when they occur, unlike cash accounting which only recognizes the transaction when a cash payment is made.
For instance, a company sells a piece of equipment to a small business for $7,000 on April 19th and sends the small business a bill that will be due on May 17th.
If the company uses accrual accounting, the company will record the revenue for sale on April 19th.
However, if the company uses cash accounting, the revenue will be recorded on May 17th since accrual accounting considers the revenue as earned when the transaction occurs, even if the payment hasn’t yet been received.
Whereas the cash accounting method only recognizes the revenue when the cash is received.
Additionally, if the business receiving the equipment uses accrual accounting, the expense must be recognized when it occurs.
Also, the liability needs to be recorded by the time the business receives the goods.
The accrued expense should be recorded in the accounts payable account, which is part of current liabilities on the balance sheet, and also on the income statement as an expense.
Then, when the company pays the bill, accounts payable will be debited, and cash will be credited.
Different Kinds of Accrual Accounts
There are many different kinds of accrual accounts, such as accounts receivable, interest revenue, accounts payable, and salaries payable.
Accounts payable is the account in which debts that a company is obligated to pay are recorded before the company pays the debts.
For a company that uses accrual accounting, expenses that are incurred by the company are recorded as a liability in accounts payable on the balance sheet and under expenses on the income statement.
Accrual Accounting Example
Suppose a retailer sells a tablet to a customer on credit for $2,000.
The customer will be taking the tablet home but will be paying for the tablet over a period of years.
However, since the business uses the accrual accounting method, the revenue from the sale will be recognized as having been earned on the day of the sale, not when the payment is received.
IRS Requirements for Accrual Accounting
The IRS does not require that all businesses use the accrual accounting method, but there are some companies that are required to use this method.
Corporations, other than S- corporations, must use accrual accounting.
Additionally, businesses whose gross receipts have averaged over $25 million for the previous three years are required to use accrual accounting as well.
What Is Modified Accrual Accounting?
Modified accrual accounting is a type of accounting method which uses concepts from both the cash method of accounting and accrual accounting.
This method is often used in accounting for government agencies, but it is not acceptable under GAAP, so public companies cannot use it.
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