When to record a business transaction in the company books of account: When it is incurred or when actual payment receives? Well, a big question? No worries. Basically, Financial accounting is based on two methods: accruals accounting and cash accounting methods. Where accrual accounting method is the one that records revenues and expenses when they incur. While cash accounting is the method that recognizes revenues and expenses when actually cash receives or is paid. This article aims to provide you with a better understanding of Accrual Accounting, its concept, its advantages and disadvantages, and the types of accruals.
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Let’s first develop an understanding of accrual accounting- what is it? And why it is used by a number of organizations?
Accrual accounting helps an organization recognize its revenues before receiving any payment for goods or services sold on credit (non-cash transaction). In the case of expenses, expenses are recognized when incurred before the organization has made payment against them.
Cash accounting is a fundamental method of accounting in which all the revenues and expenses of an organization are recorded when actually cash involves- received or paid. Small organizations prefer to use the cash accounting method because it is a straightforward and easy method. And large and medium-size organizations prefer to use accrual accounting because it depicts the true picture of the company’s financial position, and it is one of the IRS (Internal Revenue Service) standard accounting practices.
- It is an accounting method in which all the revenues and expenses of an organization are recognized in the same period in which they are incurred.
Accrual accounting is composed of two fundamental principles of accounting: the Matching Principle and the Revenue Recognition Principle.
Accrual Accounting Principles
- Matching Principle: Expenses must be recorded in the same period in which they incurred, to help generate the revenue (same year) instead of when they get paid by a company (future year).
- Revenue Recognition Principle: It says that revenue should be recorded when it has been earned or realized instead of when a company receives the cash, or you say as to when a business executes the actions that make it entitled to the revenue.
When To Use Accrual Accounting?
Where a company does any regulatory filing that needs GAAP, accrual accounting will be used in that case, Such as an organization’s 10-K annual filing at the securities & exchange commission. Most investors, financial institutions & lenders need GAAP-based financial statements whenever they want to assess a business. Talking about accrual accounting, Accrual accounting relates revenue with expense, which helps clear the company’s profitability. It also helps to show a clearer picture of an organization’s assets and liabilities in its financial position. That’s why accrual basis accounting is the method allowed by General Accepted Accounting Principles (GAAP) and securities & exchange commissions in public traded companies.
Advantages and Disadvantages of Accrual Accounting
Types Of Accruals
Expenses that are not yet paid and revenues that are not being yet received are called accruals. Before going toward categories and types of accruals, let’s first discuss its key terms- Expenses and Revenues.
Accrued Expense:
When the company receives goods & services against which no payments have yet been made, what is it? No cash involves (non-cash transaction), now what to do? You can say it is accrued expenses. Accrued expenses are the ones that have been generated in one accounting period but have not been paid till the other accounting period.
For example, a firm gets a utility for last month; this will be recognized as an expense accrual. There are several types of accrued expenses of your company you may not be even aware of about them, i.e., employee’s travel expenses, utilities you have used but have not yet been billed for, etc.
Accrued Revenue:
When the organization has provided goods or services, it doesn’t receive any payment, again non-cash transaction, how should one record this transaction? In a simpler form, you can say it is accrued revenues, accrued revenues are the ones that have been earned in one accounting period, but cash has not been received till another accounting period.
The most general example is the interest income (earned from some investments but have not yet received) & accounts receivables (the amount due on a business for unpaid goods/services.)
Now let’s move toward types of accruals.
Deferrals:
In accounting, deferral denotes a delay in recording an accounting transaction. The deferrals can arise in both revenue and expense transactions.
- Accounting for Unearned revenues/deferred revenue
- Accounting for Prepaid expenses
1. Accounting for deferred revenue/unearned revenue:
As deferred revenues are not actual revenue until they have been earned, they are not recognized in the income statement. Instead, they are identified in the balance sheet as a liability. Hence, when the income is earned, the liability gets decreased & recognized as income.
| Deferred Revenue | Also known as unearned revenue. |
| Definition | Receive cash before delivering services or goods. |
| Nature of Account | Liability |
| Adjusting entry | Decrease Liability account Increase revenue account |
Example:
Mr. A paid $2,000 for services that haven’t yet been performed. In this example, the journal entry would be:
| Account | Debit | Credit |
| Cash | $2,000 | |
| Unearned revenue | $2,000 |
Once the services get performed, the income can be recorded as:
| Account | Debit | Credit |
| Unearned revenue | $2,000 | |
| Revenue | $2,000 |
2. Accounting for deferred expenses:
Deferred expenses, also known as prepaid expenses, refer to expenses that have been paid but not incurred yet by the business. Same as deferred revenues/unearned revenue, deferred expenses are also not reported in the income statement; rather, they are recorded as an asset in the balance sheet till the expenses are generated. Eventually, when the expenses are incurred, the asset will decrease, and the expense is recognized in the income statement.
| Deferred Expenses | Also known as Prepaid Expenses |
| Definition | Pay cash before receiving services or goods. |
| Nature of Account | Asset |
| Adjusting entry | Increase expense account Decrease asset account |
Example:
Mr. B paid three months’ rent in advance. In this scenario, the journal entry would be:
| Account | Debit | Credit |
| Prepaid rent | $300 | |
| Cash | $300 |
After one month of the expense has been incurred, the expense for one month can be recorded as follows:
| Account | Debit | Credit |
| Rent expense | $100 | |
| Prepaid rent | $100 |
Accruals:
1. Accounting of accrued expenses:
An organization’s obligation is to pay for goods & services that have been provided, and invoices have not yet been paid.
| Accrued Expense | Also known as account payable |
| Definition | The expense incurred before making payment |
| Nature of Account | Liability |
| Adjusting entry | Increase expense account Increase liability account |
Example:
Let’s say for your business, you have made a rent agreement with Miss John, where you need to pay her $2,000 per month. At the month-end (January), Miss John hasn’t contacted you for the rental monthly payment. Even on 1st March 1st, still no word from her. It becomes obvious that you will not be able to pay her until she contacts you.
However, as you are using the accrual basis of accounting, your accounts will still need to show the rental expense. So, you have to make the following adjusting entry in your accounts.
| Account | Debit | Credit |
| Rental expense | $2,000 | |
| Accrued Expense | $2,000 |
You now have to show $2,000 as accrued expenses in your books of account, which reflect the $2,000 monthly rent payment you owe to her. Now let’s say she contacted you in a month later, and you pay her rental expense for the month. To close the accrued expense account from your books of account, you have to make the following entry:
| Account | Debit | Credit |
| Accrued expense | $2,000 | |
| Cash | $2,000 |
2. Accounting of accrued revenues:
Accrued revenues are ones that have been earned in an accounting period, but cash has not been received until the accounting period.
| Accrued Revenue | Also known as Revenue Receivable. |
| Definition | Deliver services or goods before receiving cash. |
| Nature of Account | Asset |
| Adjusting entry | Increase asset account Increase revenue account |
Example:
Company XYZ provides janitorial services and bills from its customers $600 at the end of the six-month period. Even though XYZ does not receive any payment till six months, the company will still make a journal entry of:
| Account | Debit | Credit |
| Accrued income | $100 | |
| Revenue | &100 |
The work has been performed without sending the bill. Hence, expenses have been incurred & revenue earned. But when cash will be received for the janitorial service at the end of six months, the journal entry in the company’s account would be:
| Account | Debit | Credit |
| cash | $600 | |
| Accrued income | $600 |
Key Points
- Accrual is the method of accounting that recognizes income when it has been earned & expenses when they have been incurred; the timing of the cash movement with the income and expense is irrelevant.
- It follows the matching principle that helps to recognize revenue and expenses when they incur.
- Accrual accounting provides a fair & true picture of a business.
- Medium & large companies use the accrual method of accounting. It exhibits what is actually happening in the industry. It assists the investors in making decisions.
