Accrual Accounting Methodology
Accrual accounting is the preferred approach for companies reporting their financial statements under generally accepted accounting practices (GAAP), which are 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.
- 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.
GAAP includes certain revenue recognition standards that companies must follow. GAAP includes certain revenue recognition standards that companies must follow to ensure that revenue is recognized when a sale has been transacted, regardless of when the customer pays. If goods are transferred to the customer, or services are provided, then revenue is recognized. If the customer has not paid, then a corresponding accounts receivable is booked, which is eliminated once the company receives cash.
However, companies still have a great deal of flexibility to enact accounts receivable procedures with varying time frames.
Accrual accounting is another term for the matching principle. This requires that companies match revenues with the expenses incurred to generate them.
A key example of the matching principle is depreciation. Let's say that a company pays for items of property, plant, and equipment in cash, it will record a reduction in cash and an increase in long-term assets, and no expense is recorded.
Depreciation allows a company to recognize that this purchase is an expense; the asset will wear up over its useful life and will need to be replaced. Since the asset will be generating additional revenue during its useful life, the company should take the cost of the asset and spread this over the useful life to match the revenue it has generated.
GAAP is required for public company accounts that are filed with the Securities and Exchange Commission (SEC). Non-listed companies may choose to follow GAAP if they require financing or if their accounts are scrutinized by a third party, for example, they are required to be audited. In any case, it is commonplace to use accrual accounting. Smaller enterprises may choose to use cash accounting as their accounts are not used externally or by third parties.
Accrual accounting highlights the fact that some cash payments for goods or services may never be received from a consumer.
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.