Under the accrual accounting method, revenue is recognized and reported when a product is shipped or a service is provided. Basically, when the sale occurs.
What Is Accrual Accounting?
Accrual accounting refers to an accounting method used to gauge a company's performance through the recognition of revenue at the time of sale. This allows for businesses to be more upfront and clearly transparent to stakeholders about the sales that are occurring. The accrual accounting method is required for publicly traded companies which must conduct accounting through the use of generally accepted accounting principles (GAAP). Many private and small businesses also use GAAP accounting standards but they are not required to.
Revenue recognition at the time of sale is a primary component to accrual accounting. Under accrual accounting any event that generates a sale constitutes the requirement for recognition of revenue on that date. Revenue recognition events can take a multitude of forms as businesses provide a variety of services and goods to their customers. Revenue recognition events can include purchase orders or billable hours.
Accrual Accounting Principles
Accrual accounting makes the process of financial accounting more complex for businesses. Since revenue is recorded and reported with purchase orders and billable service hours, the accounting team is responsible for tracking both the revenue recognition event and the accounts receivable process. This then integrates the reporting of revenue and accounts receivable across the company’s financial statements.
Revenue is recognized on the date the sale occurs and then included in a firm’s gross revenue on the income statement. Accounts receivable must be included on the balance sheet as either a short-term or long-term asset depending on the terms of payment. With accrual accounting, companies have some flexibility in structuring payment terms. The structuring of payment terms can affect the liquidity ratios of a business with many investors often closely watching the accounts receivable turnover as an important gauge for the company’s liquidity and accrual accounting efficiency.
Since company’s are not receiving immediate payment they must also integrate loss provision for uncollected payments. This uncertainty is reflected as a liability in an allowance for doubtful accounts line item on the balance sheet, which attempts to estimate the amount that customers fail to pay.
A second key component of accrual accounting is the matching principle. The matching principle is required by GAAP. With the matching principle companies must match the expenses associated with a revenue recognition event at the same time. This means expenses for the sale must be recorded as a liability on the balance sheet.
Understanding Cash Transactions
Many companies operate without a delay in payment from a sale. This can potentially confuse the concept of cash accounting. Companies that receive immediate payment for a sale can still use the accrual method. In this case, they would recognize the revenue, record the accounts receivable payment and record the expenses for the sale all at the same time. This results in a shorter days to payment measure and a more efficient accounts receivable turnover.
The cash accounting method is very different from the accrual accounting method. It may be used by some private and small businesses but it is not allowed under GAAP. With the cash accounting method, companies have a delay in the timing of a sale and subsequently receive payment. The cash accounting method records the sale and revenue at the same time when the payment is received.