ACCRUAL ACCOUNTING: A SIMPLIFIED GUIDE FOR BEGINNERS (+Detailed examples)

Accrual Accounting

Businesses involve transactions and in the course of transactions, there are tendencies of delay in payments. This brings us to our topic of discussion. In this article, you get to learn how to apply Accrual Accounting (basis, Entries, Principles, Modified and Examples for easy understanding).

What is Accrual Accounting?

This is an accounting method of recording revenues that a company has earned but is yet to receive payment for. Also, it shows the expenses which the company has not yet paid for.

Therefore, this is an accounting method where you record revenue or expenses when a transaction occurs rather than when payment is received or made. Also, the method follows the matching principle, which says that Accountants should recognize revenues and expenses in the same period.

Basis of Accrual Accounting.

Indicated below are the basis.

#1. The Basis of Accrual Accounting is a concept of recording revenues when earned and expenses as incurred. This approach also impacts the balance sheet, where receivables or payables can be recorded without an associated cash receipt or cash payment.

#2. Also, Accrual basis accounting is the standard approach to recording transactions for all larger businesses.

#3. In addition, both generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS) advocates its use.

#4. The accrual basis requires the use of estimates in certain areas. For example, a company should record an expense for estimated bad debts that have not yet been incurred. By doing so, Accountants record all expenses which relate to a revenue transaction at the same time as the revenue.

#5. Similarly, the estimated amounts of returns, sales allowances may be recorded. These estimates may not be entirely correct, and so can lead to materially inaccurate financial statements.

Accrual vs Cash

#1. Timing

The difference between cash and accrual accounting lies in the timing of when sales and purchases are recorded in your accounts (check the example below). Unlike the Cash concept, Accrual accounting recognizes revenue when it’s earned, and expenses when they’re billed.

#2. Recording

Unlike the accrual concept,  revenues are recorded when cash is received, and expenses are recorded when cash is paid in the cash concept.

#3. Expenses and Payment

Similarly, an accrual basis company will record an expense as incurred, while a cash basis company would wait for payment.

illustration of the difference between accrual accounting and cash accounting procedures (EXAMPLE).

Suppose, an automotive parts company A sold brake assemblies worth $5,000 to a client D on June 30th. D receives the bill and subsequently makes full payment on July 15th. The transaction will be recorded differently in A balance sheet under the cash and accrual methods. If A follows a cash accounting procedure, then its balance sheet will reflect a $5,000 revenue received on July 15th. If A follows an accrual accounting procedure, its ledger will show a revenue of $5,000 on June 30th.

Accrual Accounting Entries

The following points should be noted while making Accrual entries:

#1. Revenue and Expenses

Accrual accounting journal entries recognize revenues and expenses a company earned or incurred.

#2. Principles

To record accruals, accountants use accrual accounting principles in order to enter, adjust and track both expenses and revenues.

#3. Balance Sheet

The accrued assets should appear on the balance sheet and the income statement of the financial statements.

#4. Double Entries

Also, the Accrual Accounting Entries recording procedure must adhere to double entry.

Accrual accounting Principle

The accrual principle is a principle used in accounting that mandates the recording of accounting transactions in the actual period of occurrence, rather than the period of occurrence of related cash flows.

In other words, it states that accountants should record transactions when they occur not when the actual cash flow occurs.  The accrual principle is formally required by accounting frameworks across the globe, such as the Generally Accepted Accounting Principles (GAAP).

Conditions that need to be satisfied in order to properly utilize the accrual principle. These are:

#1. Depreciation

The depreciation of a fixed asset must be recorded over its useful life, and should not be charged to expense in the period of purchase.

#2. Commission

Record any commission to be paid to a salesperson at the time when the salesperson earns it. Should not be at the time when the actual payment of the commission is processed.

#3. Time of Invoicing

Record the revenue at the time of invoicing the customer, not at the time of actual payment.

#4. Time of incurrence

Record the expenses at the time it was incurred, not at the time of actual payment.

#5. Wages

Recognize wages in the period they are earned, and not in the period they are paid.

#6. bad debt

Record an estimated amount of bad debt at the time of invoicing the customer, not at the time when a default by the customer is about to occur.

Modified accrual Accounting

Modified accrual accounting is an alternative bookkeeping method that combines accrual-basis accounting with cash-basis accounting. It recognizes revenues when they become available and measurable. With a few exceptions, it also records expenditures when liabilities are incurred.

The modified accrual accounting system attempts to incorporate both the cash and accrual system of accounting. M tries to keep the cash accounting system’s convenience while incorporating the many sophistications of maintaining accounts under the accrual system.

It achieves this by categorizing the different transactions into long-term or short-term transactions. While long-term deals happen over multiple accounting periods, short-term transactions occur within a single accounting period.

Here, the short-term transactions are recorded as if the accounts are maintained under the cash accounting system. On the other hand, Accountants record the long-term transactions under the accrual method. It’s a recognized method for governments to record their accounts, but not for commercial institutions.

But the International Financial Reporting Standards (IFRS), which a majority of businesses adhere to, does not recognize modified accrual accounting as a proper system. It’s why businesses follow the accrual system of accounting.

Conclusion

This article has successfully explained Accrual Accounting. Ensure you make good use of the principles for the growth of your businesses.

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