What is accrual accounting?

What is meant by accrual accounting?

Accrual accounting is the method where revenue and expenses are recorded when they are incurred, rather than when cash is exchanged. This lets businesses get a more accurate representation of their financial position, as it reflects all transactions that have taken place, regardless of when payment is actually received or made.

By recognising revenue and expenses in the period they occur, accrual accounting provides a more comprehensive view of a company’s financial performance. This method is widely used in the business world for better decision-making based on more up-to-date financial information.

The alternative to accrual accounting is cash accounting where revenue and expenses are recorded when cash has been exchanged.

Key aspects & examples of accrual accounting

To further understand accrual accounting, understand the following key aspects:

Matching principle

The matching principle forms the foundation of accrual accounting. It states that expenses incurred to generate revenue should be recognised in the same accounting period as the revenue is recognised. This ensures a more accurate picture of a company’s profitability by reflecting the cost of generating that revenue.

For example, a restaurant will use different consumable ingredients throughout the month to make food for customers. These ingredients are an expense. Based on the matching principle, the restaurant wouldn’t just record the expenses when they’ve been paid for, rather in the same month the products were sold. This way, the restaurant gets a more accurate picture of how much it cost to make the products actually sold that month.

Accruals and deferrals

Accruals are revenue earned but not yet received and expenses incurred but not yet paid. For example, a business can provide services that won’t be paid for until after the fact. Even though the business hasn’t received the cash yet, accruals allow them to recognise it as earned income.

Deferrals are the opposite – they represent cash received in advance for services not yet rendered or cash paid in advance for expenses to be incurred in the future. A good example of this is pre-orders that are paid before the product is delivered. The advanced payment is an example of a deferral. Deferrals kind of hold that cash aside until you actually earn it by fulfilling the order.

Both accruals and deferrals are adjusted for at the end of each accounting period to ensure financial statements accurately reflect the company’s financial position.

Pros & cons of accrual accounting

While accrual accounting is used by businesses across the globe, it comes with its own complexities. Consider the following benefits and challenges:

Pros

• Accurate portrayal of profitability
• Improved comparability
• Regulatory compliance

Accrual accounting provides a more realistic view of a company’s profitability by reflecting the true cost of generating that revenue. Financial statements prepared using accrual accounting are also easier to compare between companies, especially those with different business models or cash collection cycles. This is because everyone is using the same accounting language.

Many countries require businesses above a certain size or complexity to use accrual accounting for financial reporting purposes. Accrual accounting ensures your financial statements meet these regulations. In Australia, publicly traded companies and businesses with a revenue of $10 million and more are required to use accrual accounting.

Cons

• More complex than cash accounting
• Reliance on estimates
• Not suitable for all businesses

Accrual accounting requires more bookkeeping procedures and estimations compared to cash accounting. You’ll need to track accruals (revenue earned but not received yet) and deferrals (cash received in advance for services not yet rendered) which can add complexity.

Moreover, accruing revenue and expenses often involves estimates, which can introduce potential inaccuracies in the financial statements. For example, you might estimate bad debt (uncollectable accounts receivable) or warranty expenses based on historical data.

Small businesses with a low volume of transactions or those operating solely on a cash basis might find accrual accounting overly complex and unnecessary. The additional effort required might outweigh the benefits for these businesses.

In conclusion, accrual accounting offers a more comprehensive view of your business’s financial health, but it comes with increased complexity. Consider the current stage of your business, as well as regulatory requirements, when deciding if accrual accounting is the right choice for you.