Under the accrual basis of accounting, revenues and expenses are recorded as soon as transactions occur. This process runs counter to the cash basis of accounting, where transactions are reported only when cash actually changes hands. Generally speaking, the accrual accounting method is deemed to be the superior approach for businesses seeking more accurate metrics of profitability on their income statements. For this reason, the majority of companies employ accrual accounting as their default accounting practice, even though it's arguably more complicated and subjective than cash accounting.
- Businesses use the accrual accounting method to record revenues and expenses the moment transactions occur, even if money changes hands at a later date.
- Accrual accounting is different from cash accounting, where businesses only record transactions once payments are made and cleared.
- The accrual accounting method is favored by businesses seeking more accurate measures of their profits and expenses.
Understanding Accrual Accounting
Most companies offer delayed accounts payable and delayed accounts receivable programs, allowing loyal customers to enjoy goods and services now, and pay later. This flexibility helps stimulate ongoing revenue streams that positively impact a company's bottom line over the long haul, even if no cash is immediately received. For example, a furniture store that uses the accrual accounting method may sell a sofa to a customer on credit, and immediately record the sale on its books, long before the customer finally pays the bill for the purchase.
Accrual Accounting and the Matching Principle
One of the accrual accounting method's most vital concepts is the matching principle, which states that any revenues generated must be paired with any related expenses, within the same reporting period in which the profits were earned, in an effort to eliminate confusion. This principle, as dictated by the generally accepted accounting principles (GAAP), applies to both the sale of goods and the rendering of services. Without the matching principle, financial statements would reveal little useful information because readers wouldn't gain a holistic assessment of assets and liabilities.
The matching principle pertains to employee commissions, staff bonuses, and any other payouts that may be made during a different time period than the one in which a sale occurred. Consider a jewelry boutique, where in February, a clerk sells a $20,000 diamond neckless to a customer on credit. Let's assume the clerk is entitled to collect a 10% commission on the sale, which the customer ultimately pays for in April. According to accrual accounting rules, the boutique must record the $2,000 outgoing commission payout to the clerk, in its February's expense reports, even though the clerk won't pocket the money until two months later.
Drawbacks to the Accrual Accounting Method
While the accrual method does present a more accurate picture of a company's financial profile, this process can make it difficult for businesses to precisely track how much cash they actually have handy. Failure to carefully monitor cash flows autonomously from their accrual accounting practices may land businesses in overextended financial positions.
For most accounting software, such as QuickBooks, the default setting for all financial reports is the accrual accounting method.