The accrual accounting method describes the business practice of recording revenues and expenses during the exact time in which goods are sold, or services are performed, regardless of whether or not any cash changes hands. Accrual accounting is the alternative to the cash accounting method, where businesses only record revenues and expenses during occasions when cash is actually received or paid out. Generally speaking, accrual accounting is used when a company seeks clarity of its performance metrics over a specified time period by providing a more accurate snapshot of its fiscal activities.
Practical Examples of Accrual Accounting
Accrual accounting can occur if a company records its revenue on its income statement covering the time period in which goods or services are provided, where a company bills its clients on credit terms but does not get paid until later. Similarly, if the company itself purchases materials or other supplies on credit, it records those expenses on its income statement during that time, even if it pays the balance due on some future date. Accrual accounting practices more accurately reflect the revenues and expenses during a given time period, ultimately enabling companies to achieve more accurate gross, operating, and profit margin analyses.
Under the cash accounting method, where revenues and expenses are only recorded if and when cash is actually received or paid, companies can obtain more accurate snapshots of their cash flows. Simply put: if a company bills its clients on credit terms, it waits until that debt is officially paid before recording this revenue on its balance sheet. For example, if a furniture store sells a customer a leather sofa on credit in February, but does not receive payment until April, the revenue for this sale is not recorded until April. This method lets cash-strapped companies know precisely the amount of cash they have on hand, to prevent over-extension and allow for shrewder budgeting.