Managing a company is a complex process that involves multiple variables, including capital, revenue, and expenses, along with reporting to stakeholders. Most companies start with a specified amount of capital gained through equity or debt to get their business running and then maintain this capital level for efficient operations.
While some small businesses may be able to fully manage the business on a cash basis, it is much more common for businesses to stretch out their revenue recognition and receivables over time. This is where accrual accounting comes in.
- There are two accounting methods practiced by companies: the accrual accounting method and the cash accounting method.
- Only the accrual accounting method is allowed by generally accepted accounting principles (GAAP).
- Accrual accounting recognizes costs and expenses when they occur rather than when actual cash is exchanged.
- The matching principle of accrual accounting requires that companies match expenses with revenue recognition, recording both at the same time.
- Only public companies are required to use the accrual accounting method.
Accrual Accounting Methodology
Accrual accounting helps a company to maximize its operational abilities by spreading out its revenue recognition and receivables. The increased efficiency advantage is one of the main reasons that generally accepted accounting principles (GAAP) requires accrual accounting; the reporting of sales is another.
In general, accrual accounting provides for a better sense of a company's overall financial health than the cash basis accounting method. That is primarily why it has been adopted as a best practice and integrated into the broad set of rules defined through generally accepted accounting principles (GAAP) and issued through the standards of the Financial Accounting Standards Board (FASB).
Accrual accounting requires companies to record sales at the time in which they occur. Unlike the cash basis method, the timing of actual payments is not important. If a company sells an item to a customer through a credit account, where payment is delayed for a short term (less than a year) or long term (more than a year), the accrual method records the revenue at the point of sale.
This can be important for showing investors the sales revenue the company is generating, the sales trends of the company, and the pro-forma estimates for sales expectations. In contrast, if cash accounting was used, a transaction would not be recorded for a while after the item leaves inventory. Investors would then be left in the dark as to the actual sales performance and total inventory on hand.
GAAP and FASB have certain revenue recognition standards that companies must follow, which provide some limitations on policies involved in the process of transacting a sale and collecting its payment. However, companies still have a great deal of flexibility to enact accounts receivable procedures with varying time frames.
One of the most important provisions of GAAP’s accrual accounting revenue recognition is the matching principle, which is a crucial element for companies. The matching principle requires that companies match expenses with revenue recognition, recording both at the same time.
Accrual accounting highlights the fact that some cash payments for goods or services may never be received from a consumer.
It is important to know that GAAP is not law and is only required for companies that are publicly traded. Many smaller, private companies use the cash basis method for its simplicity. While this can work, companies listed with the Securities and Exchange Commission (SEC) need the accrual basis for realistic reflections of their business activities and greater transparency for stakeholders.
Evaluating Accrual Accounting
While accrual accounting is known to help increase operational efficiency in practice, it can present some higher risks; primarily regarding collections. Thus, there are a few considerations for investors when analyzing the accrual accounting operations of a business.
One of the main ways to assess the efficiency of a company’s accrual accounting is to survey the accrual accounting impact across all of the company’s financial statements. Accrual accounting allows a company to book revenue on its income statement at the time of the sale. These revenues then carry over to accounts receivable on the balance sheet and may lead to operating charges in the operating portion of the cash flow statement if payments are not received.
On the balance sheet, the receivables turnover ratio can be a good metric for helping to evaluate the efficiency of a company’s accrual accounting and revenue recognition procedures. On the cash flow statement, a high amount of operating charge-offs or an increasing amount of receivable charge-offs can also be important to watch.
The Bottom Line
Companies can use the accrual accounting method or the cash method when preparing their financial statements; however, if a company is public, it must use the accrual accounting method as specified by GAAP.
GAAP prefers the accrual accounting method because it records sales at the time they occur, which provides a clearer insight into a company's performance and actual sales trends as opposed to just when payment is received.