Transactions when recorded as they happen and not when the actual payment has been made follow the accrual basis of accounting. This blog outlines what it is and how it works.
Walter Harvey Pvt Ltd, a cloth manufacturing company, sold 1000 men’s shirts on credit to a clothing store and generated an invoice on March 10, 2022. The company will receive the order payment on March 22, 2022. Still, it recorded its sales on the date it generated the invoice.
Walter Harvey received raw material for an upcoming order on March 12, 2022. On the same lines, it recorded that expense on the date it received the order, i.e., March 12, 2022, although it paid the supplier on March 16, 2022.
However, when it paid rent from April to June 2022, in advance, i.e., on March 31, 2022, it didn’t recognize it as rent expenses in March. This is because those rent expenses belonged to April to June 2022 but were paid on March 31, 2022. Likewise, Walter Harvey makes provisions for utility expenses accordingly at the end of every month. However, it makes the actual payment in the subsequent month.
Walter Harvey records its income tax expenses as per the revenue generated in the financial year, regardless of the actual payment.
Here, it is evident that Walter Harvey books its expenses and revenue in the period for which they are related and not in the actual cash inflow or outflow period. This suggests that Walter Harvey Pvt Ltd follows the accrual principle in accounting.
Every company follows certain rules or methods to report its revenues and expenses. Such a set of rules is called an accounting method. Primarily, there are two types of accounting methods – accrual accounting and cash accounting. The main difference between the two accounting methods relates to the time when revenue and expenses are recognized.
Here you’ll be guided about what accrual accounting exactly is, how it works and what are its benefits and limitations.
What does it actually mean?
Accrual accounting is a method for financial accounting that enables a company to report revenue earned even before receiving payment for goods or services sold or to report expenses as incurred before the company has actually paid for them in the books of account. The accrual principle aims to report revenues and expenses within the same period, which is known as the matching principle.
To put it another way, the revenues earned and expenses incurred are reported in the company’s books of account, not considering when cash flow has happened. The other financial accounting method, though, cash accounting, reports the revenues earned and expenses incurred when the cash transactions have taken place in reality.
What is “accrual” in accounting?
The word “accrual” in accounting refers to the revenue earned or expense incurred that impacts the company’s net income on the income statement. Still, the cash inflow and cash outflow related to the revenue or expense have not yet occurred.
How does it work?
In a company that follows the accrual concept in accounting, the accountant reports the revenue from a sales order and the related expenses. As both amounts are reported in the same period, the company’s financial statements give a precise interpretation of its profitability.
This means the accountant reports the revenue once the revenue can be recognized (most probably, once the products have been shipped or services have been given). Therefore, the accountant creates an invoice from the sales order (having each product’s name, quantity, and amount to be paid). Also, the accountant reports the cost of products sent, which comes from the database of inventory costs. Now, as the sale has been reported already, the cash receipt from a customer will not affect the sales figure. Rather, it shows a reduction in accounts receivable.
Example of accrual accounting
Assume that you own an art supply store. You sell art supplies to professional artists, art students, art hobbyists, and art colleges. One of your most loyal customers, an art college, orders 50 oil color boxes from your store. However, it states that it cannot pay all the amount at once.
Considering this scenario, you allow the art college to pay later and accordingly make a credit sale agreement. After that, you sell 50 oil-color boxes to the art college on credit. According to the terms of your agreement, the customer (the art college) would take some time to pay your store in full for the oil colors.
Using the accrual concept, you will report the accrued revenue from the sale when you generate an invoice. The oil color boxes leave your store and not on the date in the future when the customer makes the complete payment.
Is it feasible?
Business transactions are often complex, especially for large businesses. Using the accrual basis of accounting serves as a solution to this complexity. Most large companies follow the accrual principle in accounting. Such companies sell products or services on credit and keep on receiving revenue over a long time from products or services sold in some previous period.
If these companies record their transactions when the payments happen, it will show an inaccurate picture of their financial position. The market requires an accurate representation of a company’s finances. So, the accrual accounting method allows large businesses to convey the most accurate picture of their financial position.
Moreover, investors prefer accrual accounting. A company that follows this method is often considered more well-established than otherwise.
When a company wants to assess its performance for a specific period (such as a quarter or a financial year), the accrual concept in accounting proves to be efficient.
In the accrual basis of accounting, future revenues and expenses can be accounted for. In this way, the financial activities reported in the balance sheet allow the company to calculate crucial financial metrics such as operating margin, gross profit margin, and net income.
A Few Limitations
There are a few limitations to accrual accounting.
Consider the example of Walter Harvey Pvt Ltd again.
What if Walter Harvey never pays its supplier for the raw material? Or, what if it never gets paid for the products it has already sold on credit?
Besides being a financial problem, this would also be an accounting concern. As the company follows accrual accounting, its books of account may indicate that it is generating profits. In contrast, the reported cash flows are still to be received.
In such cases, the company can be portrayed as profitable even if it lacks cash flow sufficient to run its day-to-day operations. Eventually, it may even get bankrupt, regardless of the profits shown on its financial statements.
Moreover, accrual accounting might not be useful for small companies, considering that it requires a dedicated staff – an entire department to track and report revenues and expenses.
Also, when a company records income even before the actual cash inflow, it may end up paying taxes on that income even before receiving it.
The Bottomline
Based on the matching principle, the accrual basis of accounting records revenues earned and expenses incurred for a specific period when products or services are delivered. It is beneficial for large businesses and market participants to provide a more accurate financial representation. However, it has a few limitations, mostly related to the representation not being the same as the reality. Overall, for precise reporting, the accrual concept is mostly preferred by large businesses and market participants.
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