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Accrual accounting

Accrual accounting definition

Accrual accounting is a method of accounting whereby a company’s position and performance is measured by recording all cash transactions that occur, rather than simply recognising payment transactions. The latter method is known as cash accounting.

Key takeaways:

  • Accrual accounting is a method of accounting that records revenues and expenses when they are earned or incurred, regardless of when cash is received or paid.

  • Accrual accounting provides a more accurate representation of a company's financial position and performance by recognizing economic events as they occur, rather than when cash transactions take place.

  • Under accrual accounting, revenues are recognized when they are earned, meaning when goods are delivered or services are rendered, even if payment is not received at that time.

  • Similarly, expenses are recorded when they are incurred, such as when goods or services are received, regardless of when payment is made.

How accrual accounting works?

Accrual accounting adheres to the matching principle, recognising financial events at the time when the transaction takes place instead of when payment is made or received.

An accrual in this instance can refer to revenues a company has earned but not yet been paid for and expenses a company has incurred but not yet paid.

Accrual accounting explained

The process would be unnecessary if companies received cash payments for revenues at the exact time they were earned, and paid all expenses exactly when they were incurred. However, as the payment of both revenues and expenses for the majority of firms is not so immediate, a method is required to keep stock of receivables and payables.

Accrual accounting came to prominence as business practices became more complex over the last century. To recognise payments spread across an extended period, for example buying or selling on credit, using the cash accounting method could run the risk of distorting the actual state of a business.

By reflecting events within the same reporting period, companies are able to gauge more immediately their expected incomings and outgoings and thus make better business decisions.

Accrual accounting benefits

  1. Accurate Financial Reporting: Accrual accounting provides a more accurate depiction of a company's financial position and performance by matching revenues with related expenses in the same accounting period. This enables stakeholders to make informed decisions based on reliable and transparent financial statements.

  2. Better Revenue Recognition: By recognizing revenues when they are earned, even if payment is not received at the time, accrual accounting allows businesses to reflect the true value of their sales and services. This is particularly beneficial for businesses with long-term contracts or deferred revenue.

  3. Expense Allocation: Accrual accounting enables the proper allocation of expenses to the accounting period in which they are incurred. This ensures that expenses are recognized in the same period as the related revenues, providing a more accurate representation of profitability.

  4. Comprehensive Financial Analysis: Accrual accounting provides a more comprehensive view of a company's financial performance by considering all economic events, regardless of cash movements. It allows for effective financial analysis, such as ratio analysis, trend analysis, and benchmarking, enabling better decision-making.

  5. Better Management of Cash Flow: Accrual accounting helps in managing cash flow more effectively by allowing businesses to anticipate future cash needs. It provides insights into expected future revenues and expenses, facilitating cash flow planning and budgeting.

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