Accrual accounting is the basis according to which “the effect of transactions and other events is recognized when they occur (and not when cash or cash equivalents are received or paid)”. They are reflected in the accounting entries and in the financial statements in the periods to which they relate. Thus, accrual accounting includes all the tools developed by accountants to apply the compliance rule. The method includes two main methods:
- reflection in accounting for income at the time when they are earned and expenses at the time they are incurred;
- adjustment of accounts.
The first accrual accounting method was illustrated several times in the chapter on measuring business transactions. For example, when the Joan Miller advertising agency placed advertisements for its clients on credit (transaction dated January 19), the revenue was taken into account when the “Accounts receivable” account was deducted and the “Advertising revenues” account was credited. Therefore, credit sales are recognized as income before cash is received. The “Accounts receivable” account is considered a holding account until payment is received. The process of determining when a sale occurred is called revenue recognition.
Further, when the Joan Miller advertising agency received a bill for telephone calls on January 30, the expense was recognized, on the one hand, as already incurred, and on the other, as contributing to generating income in January. The transaction was reflected in the debit of the account “Phone expenses” and the credit of the account “Accounts payable”. Until payment of the invoice, “Accounts payable” is a holding account. Please note that expense recognition does not depend on whether or not cash was paid.
The accounting period, by definition, ends on a specific day. The balance sheet should contain all assets and liabilities at the end of this day. The profit and loss statement should contain information on all income and expenses for the period ending on the same day. Economic activity is a continuous process, however, in order to compile periodic reports, you should choose some kind of “cut-off point”. Some operations invariably cover the “cut-off point,” so adjustments to billing are needed.
Accrual accounting is the standard accounting practice for most companies. The exception is companies with very small volumes of activity. This method provides a more accurate picture of the current position of the company, but its relative complexity makes its implementation more expensive. This method is the opposite of the cash method, which only recognizes transactions when cash is actually exchanged.
The need for this method occurs due to the increasing complexity of business operations and the need to obtain more accurate financial information. Credit sales and projects that provide a stream of income over a long period of time affect the financial condition of the company at the time of the transaction. Therefore, it makes sense that such events are reflected in financial statements during the same reporting period when these transactions occur.
For example, when a company sells TV to a customer who uses a credit card, accrual accounting and cash accounting will reflect this event in different ways. Income generated by the sale of a television will only be recognized on a cash basis when the company actually receives the money. If the TV is bought on credit, this income can be recognized next month, or even next year.
Accrual accounting asserts that the cash method in this case is not accurate because there is a high probability that the company will receive cash at some point in the future because the sale has already been made. Therefore, the accrual accounting method recognizes the sale of the television at the moment when the customer transfers ownership of the television. Even though the cash is not yet in the bank, the sale is accounted for in an account known as “receivables” in accounting, which increases the seller’s income.