Accrual Accounting

Definition

Accrual accounting is a method of accounting that records revenues and expenses when they are earned or incurred, regardless of when the actual cash payment is received or made. This contrasts with cash-basis accounting, which records transactions only when cash is exchanged.

5 Must Know Facts For Your Next Test

1. Accrual accounting provides a more accurate representation of a company's financial performance by recognizing revenues and expenses in the period they are earned or incurred, rather than when cash is exchanged.
2. The matching principle is a key tenet of accrual accounting, ensuring that revenues and their associated expenses are recognized in the same accounting period.
3. Accrued expenses, such as utilities, rent, or salaries, are recorded on the balance sheet when they are incurred, even if they have not yet been paid.
4. Accrual accounting allows for the recognition of accounts receivable and accounts payable, providing a more comprehensive view of a company's financial position.
5. The use of accrual accounting is required for publicly traded companies and is considered the standard practice for most businesses, as it provides a more accurate and meaningful representation of financial performance.

Review Questions

• Explain the economic basis for accrual accounting and how it differs from cash-basis accounting.
  • The economic basis for accrual accounting is that it provides a more accurate representation of a company's financial performance by recognizing revenues and expenses in the period they are earned or incurred, rather than when cash is exchanged. This is in contrast to cash-basis accounting, which records transactions only when cash is received or paid, regardless of when the underlying economic event occurred. Accrual accounting follows the matching principle, ensuring that revenues and their associated expenses are recognized in the same accounting period, giving a more comprehensive and meaningful picture of a company's financial activities.
• Describe how a company recognizes a sale and an expense under accrual accounting.
  • Under accrual accounting, a company recognizes a sale when the revenue is earned, regardless of when the cash is received. This may involve the recording of accounts receivable, which represent the amount owed by customers for goods or services provided. Conversely, a company recognizes an expense when it is incurred, even if the cash payment has not yet been made. This can involve the recording of accrued expenses, such as utilities, rent, or salaries, on the balance sheet. The matching principle ensures that these revenues and expenses are recognized in the same accounting period, providing a more accurate representation of the company's financial performance.
• Explain the relationship between the balance sheet, income statement, and statement of cash flows under accrual accounting, and how this differs from cash-basis accounting.
  • Under accrual accounting, the balance sheet, income statement, and statement of cash flows are all interconnected and provide a comprehensive view of a company's financial position and performance. The balance sheet reflects the company's assets, liabilities, and equity, including accounts receivable and accrued expenses, which are recognized under accrual accounting. The income statement reports revenues and expenses in the period they are earned or incurred, regardless of when cash is exchanged. The statement of cash flows, on the other hand, shows the actual inflows and outflows of cash during the period. This relationship between the financial statements is crucial for understanding a company's financial health, as accrual accounting provides a more accurate and meaningful representation of the company's economic activities compared to cash-basis accounting.

Related terms

Cash-Basis Accounting: An accounting method that records revenue when cash is received and expenses when cash is paid, regardless of when the underlying transaction occurred.

Matching Principle: The accounting principle that requires companies to match revenues with the expenses incurred to generate those revenues in the same accounting period.

Accrued Expenses: Expenses that have been incurred but not yet paid, such as utilities, rent, or salaries.