The accrual principle is an accounting concept that requires transactions to be recorded in the time period in which they occur, regardless of when the actual cash flows for the transaction are received. The idea behind the accrual principle is that financial events are properly recognized by matching revenues against expenses when transactions – such as a sale – occur, rather than when the actual payment for the transaction may be received.
Following the accrual principle in accounting provides a more accurate picture of the actual financial status of a company, but it is a more onerous method for small businesses to adopt.
Large businesses consider the accrual principle the most valid accounting system for determining the financial position and cash flows of their business operations, with revenues and related expenses recorded within the same reporting period. Businesses earning over $5 million in revenues are required to use the accrual principle for tax purposes.
Accrual Accounting vs. Cash Accounting
The main difference between accrual accounting and cash accounting lies in the period in which revenues and expenses are recorded as having occurred.
Accrual accounting method
The accrual method of accounting is based on matching revenues against expenses in the period in which the transaction takes place, instead of when the payment is processed, which is the procedure with cash accounting. The accrual method requires businesses to factor in “allowance for doubtful accounts” since goods are delivered to customers prior to payments being received, and some customers may fail to pay.
On the other hand, some customers may pay for the goods before the goods are delivered to the purchaser. In such an instance, the payment is initially recorded as a liability for the seller (because, having received the payment, the business is then liable for delivering the goods).
When the goods are delivered to the customer, the payment is transferred from the liability account to the revenue account. Similarly, when an expense bill is received, it is recorded in the expense account as such, even before payment for the expense is made.
Cash accounting method
The cash accounting method records revenue and expense transactions when the payments are physically received or paid out. This method is restricted to small businesses that do not have significant volumes of transactions. The advantage of this method over the accrual method of accounting is that a business can account for all the physical money it has on hand.
However, if the business sells goods on credit through internal financing, then it would be unable to account for the future payments, since cash accounting, unlike the accrual accounting method, does not have a means of recording future payments. Therefore, a business that uses the cash accounting method may not always present the most accurate view possible of its real financial position.
The Need for the Accrual Principle
The complexity of business transactions
The accrual method of accounting came into use as a response to the increased complexity of business transactions. Large companies that sell goods on credit may continue to receive revenue over a long period of time from goods that were sold earlier. Recording such transactions when the payments occur would reflect an inaccurate picture of the company’s financial position, whereas the financial markets require timely and accurate reporting of a company’s finances.
With the accrual accounting method, large businesses can present the most accurate picture of the financial position of the company.
Measuring the performance of a business in a particular period
When a business wants to examine its actual performance during a specific period of time – such as a quarter or one fiscal year, the accrual method of accounting is a useful tool. It is based on the matching principle, where revenues are recorded for the period when goods and services are delivered, and expenses are recorded when goods and services are purchased (thereby matching revenues earned against expenses incurred during the same accounting period).
One reason accrual accounting is able to provide a more accurate overview of a business’ performance over a specific time period is that future revenues and expenses can be accounted for. The financial information recorded under accrual accounting enables the business to calculate key financial metrics such as gross profit margin, operating margin, and net income.
Why GAAP uses Accrual Accounting rather than Cash Accounting
Accurate and consistent reporting
The primary goal of GAAP is to have accurate and consistent rules for financial reporting. Using the accrual accounting method helps to achieve this key goal. Whenever a business sells an item, even on credit, the transaction is recorded immediately, regardless of whether or not payment is made at that time.
If GAAP favored using the cash accounting method, then the sale of goods sold on credit would not be recorded when the transaction occurs, thus creating an imbalance – a discrepancy – between the inventory and sales recorded.
In accrual accounting, a business records the revenue transaction when the revenue is earned. For example, let’s assume that ABC Company has been contracted by XYZ Company to supply construction materials worth $200,000 at its New York construction site. The payment is to be made within 90 days from the date of delivery.
When ABC delivers the construction materials to XYZ, it records the transaction as revenue in its books of accounts. The time when payment is received, or is to be received, does not affect the recording of the revenue.
Limitations of the Accrual Principle
The significant limitation of the accrual principle of accounting is easily seen by looking at the example just provided: Suppose that XYZ Company never makes a payment for the construction materials? Obviously, such a situation would present a genuine and substantial financial problem for company ABC, but it would also present the company with a significant accounting problem.
Accrual accounting may indicate that a business generated profits during a specific accounting period while the recorded cash flows are yet to be received. Potentially, it can portray the business as profitable even when it lacks sufficient cash flow to finance its operations. In cases of extreme cash flow shortages, the business may even become bankrupt despite showing current profits per its financial statements.
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