If a transaction is recorded when it occurs and not when the cash is received for the transaction, this is the accrual method of accounting. It is a fundamental accounting concept that is used in accounting standards such as GAAP (Generally Accepted Accounting Principles).
The accrual concept allows a company to document economic changes regardless of whether cash is received at the time or not. It allows a company to view cash outflows and inflows at a particular time to give an accurate picture of a company’s finances.
Accrual Concept of Accounting Video Tutorial With Examples
Accrual Concept of Accounting Video Example
Accrued expenses are recorded when a business has used a product or service but has not paid cash for it yet.
Accrued Expenses Example
A company may purchase office equipment using their credit account at a retailer and may not be required pay for the equipment for one month.
There would be an accounting entry made to debit the office equipment account the amount that was spent and the same amount would be credited to accounts payable. Once the invoice is received for the office equipment after a month and paid in cash, the office equipment account would be credited and accounts payable would be debited the amount of the payment.
Accrued revenue refers to a transaction in which a company has not received cash, but has made a credit sale. The credit sale is recorded when the customer takes the product or uses the service. After a credit sale, the company would make an entry to credit sales and debit accounts receivable. Once the customer has paid for the product or service, accounts receivable would be credited.
Cash vs Accrual Accounting
There are several advantages and disadvantages to using accrual accounting compared to cash accounting. Most companies use accrual accounting because it gives an accurate financial picture when there are credit sales. Cash accounting only records sales when a business is paid in cash, not when a credit sale occurs.
Cash Accounting Inaccuracy Example
A business may sell half or more of its products on credit, and it may take customers four months to send their payments in cash. If the business uses the cash method of accounting, it does not report any of its credit sales until they are paid in cash.
As a result, the company’s financial picture for one quarter may be inaccurate, because none of its credit sales would be reported until customers paid in cash in the following quarter. Going by the same logic, the profit for one quarter may be reported as higher than it should be for this company, because the expenses associated with the profit would be left out (since those expenses were reported in the previous quarter).
If the company used the accrual method of accounting, it would have recorded the credit sales on the day they occurred. Any expenses associated with the sales that occurred that day, such as employee costs, advertising, and other expenses would also be recorded at the same time. Thus, the financial picture is much more accurate and the quarterly profit report will include all of the expenses and expected credit sale revenue.