Accrual Method of Accounting

Introduction

Accrual is the accounting method in which revenues on the income statement are accepted when they earned, instead of the time period during which cash is received. It also has an impact on the balance sheet during the time of revenues either through increase in cash (in case the sale or service was for cash), increase in Accounts Receivable (provided the service was performed on credit) or decrease in Unearned Revenues(provided the customer had made advance payments, after which service was performed).

Accrual Method

In accrual method of accounting, expenses match with revenues in income statement when they expire or in case the title gets transferred to the buyer, instead of the time when payments are paid for expenses. Balance sheet also gets affected during the time of expense by increase in Accounts Payable (provided the expenses will be paid in future), or a decrease in Prepaid Expenses (if expenses were paid beforehand) or a decrease in Cash (if expense was paid during the time when the expense was made).

Cash Method

This method of accounting is usually employed by small businesses. In this system of accounting, income isn’t counted until and unless cash is not received and expenses are not counted till they are paid. When you record transactions using the cash method, it affects your company’s accounts only once after a completed financial transaction has taken place. So, it is less accurate in comparison to accrual accounting for short term periods. For example, a real estate company acquires a major contract in a specific year, but it will be paid for the work done only after it has been completed. If the company uses the cash method of accounting, it will be able to calculate its revenues only once the project gets completed, and record the expenses as they get paid out from time to time. In case the project takes more than one year to get completed, then there will be a mismatch in the company’s income statements. It will make big losses in one year, and greater profits in the next.

Advantages and disadvantages

As compared to cash method, accrual basis of accounting is more popular. By matching expenses and revenues, it helps organizations to make financial statements which are unaffected by timings of cash transactions. As a result the financial statements made provide a clear picture of a business’s financial health. Matching of the revenues and expenses also helps in conducting more useful analysis of any business. One big drawback with this method of accounting is that all transactions need to be recorded as per the time periods when they occur. As invoices don’t occur at the same time as actual events, accountants have to resort to estimation and guesswork.

Conclusion

Accrual basis of accounting is widely used in preparing financial statements according to Generally Accepted Accounting Principles (GAAP) due to its matching principle.

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This article has been compiled by Evelyn, who is a writer on various academic topics.