Accrual basis and cash basis accounting are the two basic accounting methods used by businesses. Here, we will dive in more on what accrual accounting is and why is it better to use this method instead of the cash basis.
On an accrual basis Accounting records revenue and expenses as soon as they are generated, rather than when money is exchanged.
This means that revenue is recorded when it is earned rather than when it is collected. It also requires recording expenses when the company bears the risk rather than when they are paid.
Accrual accounting, regardless of the size of your organization, usually provides a better indicator of success because it reveals when the underlying income and expenses occurred.
On the other hand, it can be more difficult and time-consuming. Accounting software by Jurnal can help, greatly simplifying what could otherwise be a time-consuming chore.
Jurnal also comes with inventory software to help you manage your stock levels.
What is Accrual Basis Accounting?
Accruals are accounting entries for expenses or revenue for which no payment has yet been received.
While accruals may have an influence on your company’s net income on the income statement, keep in mind that the cash hasn’t arrived yet.
Accruals can be used for a wide range of financial operations, such as accounts receivable, payable, and payroll.
Simply put, an accrual accounting entry might include any sort of revenue that has been earned but not yet recorded in the books, as well as any expenses or liabilities that have been spent but not yet recorded.
How Does Accrual Accounting Work?
It’s important to understand what makes an accrual in accounting in order to grasp this specific method.
Adjustments that must be made before a company’s financial statements are produced are referred to as accruals.
They include expenses, losses, and liabilities that have occurred but have not yet been recorded in the accounts, as well as income and assets that have been earned but have not yet been recorded.
As a result, the goal of accrual accounting is to match revenues and expenses to the time periods in which they were incurred (the matching principle), rather than the timing of the actual cash flows associated with them.
Accruals are used to indicate the transaction’s underlying economic reality.
It’s a particularly beneficial strategy in firms with a high volume of credit transactions, such as when goods and services are sold on credit rather than cash.
In accounting, accruals are divided into two categories: revenues (receivables) and expenses (payables).
Benefits of Using Accrual Basis Accounting
Accrual accounting offers a number of advantages. For instance, it improves the quality of your financial statements and ensures that you have a better understanding of the financial health of your business.
Not only will you get a clear picture of the cash your company owes, as well as the money you owe to other companies, but you’ll also be able to see projected expenses and profits in the next accounting period.
Here are some other benefits of using this accounting method:
- Provides a more realistic view of a company’s performance and financials.
- Assists the company in making more financial decisions.
- It may be easier to obtain long-term financing as a result of this (most lenders and investors will require that your financial statements are prepared according on the accrual basis).
However, there are also some disadvantages:
- It can be more complicated and require more careful monitoring of the invoices.
- Prior to the consumer actually paying the bill, tax must be paid on the income. This could lead to cash flow problems in the short run. (Keep in mind that if your customer does not pay the invoice, you can claim the tax back on a later return.)
Example of Case Study
Let’s look at an example to gain a better understanding of accrual accounting. Assume your company’s production equipment requires regular maintenance starting in the last month of the accounting period.
The bill, however, will not be paid until the first month of the following accounting period, when the job is completed.
You must declare the expense on the income statement for the current year and the accompanying liability on the balance sheet as of the last day of the accounting period to guarantee that your financial statements are comprehensive.
You’ll next need to make an adjustment entry that debits the maintenance charge and credits your accumulated expenses payable to record the accrual.