All of the big companies on the stock market use the accrual basis of accounting but what is accrual based accounting? We’re going to explore what the accrual basis of accounting is, why it is used, an example and how it differs from the cash basis of accounting. Stick with us, take it slow, wrap your head around the concepts and you’ll have no problem understanding the accrual basis of accounting.
What is Accrual Based Accounting?
Accrual accounting is one of the two main accounting systems, the other being the cash basis of accounting. It is the most accurate way to perform accounting so you can know when revenues are earned and expenses are incurred. That is almost a look at the definition so let’s introduce the formal definition.
Accrual Accounting Definition (Beginner Friendly)
The definition of accrual accounting is revenue is recognized as it is earned and expenses are recognized as they are incurred.
What is this saying? Accrual accounting records revenue when the substance of the accounting takes place. It is easier to see visually with an example.
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How Does Accrual Accounting Work? [Accural Accounting Example]
Let’s take the example of a lumber company that sells wood boards to builders. On June 1 they sell $1,000 of wood boards to a builder with payment due in 30 days. The builder pays the lumber company on July 1.
Under accrual accounting, the lumber company would record its revenue on June 1 as the substance of the transaction has taken place.
Let’s compare this to cash basis just to even make it clearer. Under cash basis, the revenue would be recorded on July 1 when payment changes hands.
See how this would record revenue in the incorrect period? A similar theory applies to expenses.
The lumber company goes to the store to buy a saw blade for $250 on June 15. The company sends an invoice on June 30th. The lumber company pays the bill on July 15.
For this example, under the accrual basis, the lumber company should increase accounts payable on June 30th when they have been invoiced and debit materials expense. On July 15, they will record the payment by crediting cash and debiting accounts payable.
Under the cash basis, the transaction would be booked as an expense on July 15 when cash is paid. There would be no accrual for the expense on June 30th. This creates a timing difference between the cash basis and accrual basis of accounting.
Accrual Accounting Benefits: Why It is Used
The data is so much clearer with accrual accounting. It provides the most accurate reporting for the period that revenues are earned and expenses are incurred. Investors want to see a clear and accurate picture so they can make decisions.
Accrual Accounting Versus Cash Accounting: What’s The Difference
We touched on the difference between accrual and cash accounting above in the example but the key point to know is that with cash basis accounting, revenue and expenses are recorded when cash changes hands.
For accrual accounting, revenues are recorded when earned and expenses are recorded when incurred. Generally speaking, the cash and accrual basis will provide timing differences since the timing of recognition is different.
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Why Accrual Accounting is Better than Cash (Important)
There’s not much of a debate. Accrual accounting is better than cash accounting because it provides a more accurate representation of transaction timing.
There is a clearer picture of the finances of a business using accrual accounting vs using cash basis. This is the reason that Generally Accepted Accounting Principles (“GAAP”) requires the accrual basis.
Let’s Recap Accrual Based Accounting
- Accrual accounting recognizes revenues when earned and expenses when incurred.
- It is used by publicly traded companies and many small businesses as well.
- Accrual accounting is compliant with Generally Accepted Accounting Principles.
- The accrual basis provides a clear picture of a business’s finances and the timing of transactions.
What is Accrual Based Accounting? Final Thoughts
The accrual basis of accounting costs a bit more to implement than cash accounting but it is well worth it since it provides the best records for a company.
This is especially true when there are investors in the company or stakeholders who want the most accurate picture. Work some accrual accounting problems, reread the material and you’ll have no trouble grasping accrual accounting.
