Concepts that are the Basis of Accrual Accounting

Concepts that are the Basis of Accrual Accounting.

Accrual Accounting is an accounting method where the revenues earned or expenses incurred are recorded when the transaction takes place and not when the payments are received. Generally accepted Accrual accounting principles requires transactions to be recorded in the period of occurrence not considering the period incomes are received. It is based on the matching revenues against expenses when a transaction takes place regardless of when the actual payment is made. In the business that uses the accrual accounting method, the payments received from customers are recorded as a liability account before their goods are delivered to them. While when the goods are delivered to them, payments change from liability to revenue account. When the expense bill is received it is recorded in the expense account before payments are received. Accrual basis accounting includes; 1. Cash Flow Statement– the number of cash equivalents brought in the firm is computed in the cash flow statements before they are taken. This statement shows the performance of the company. The balance sheet and income statement form cash flow statements. 2. Prepaid Expense– These are payments that are received in advance. These prepaid expenses are recognized as an asset. Future costs are saved when the expenses are prepaid. 3. Depreciation. The assets value decline over a period of time by wearing or tearing. Therefore, the original value is lost. Below is an example; Salary expenses: salary expense is recognized at the end of the month in the income statements when the staff is paid the salary at the end of the month. Accrual salary expense entries will be as follows; Before salary is paid Dr. Salary Expenses (Income Statement) Cr Salary Expenses (Balance Sheet) After salary is paid Dr. Salary Expenses (Balance Sheet) Cr Cash/Bank (Balance Sheet) As the accrual method deals with earned revenue and incurred expenses, there are two concepts that form its basis. They include revenue recognition principles and matching concepts.

Revenue Recognition Principle

Revenue is the cash flows generated from selling products and services to the customers. The revenue recognition principle states that a business should earn and realize revenue before it is recorded. The Revenue Recognition Principle is the concept that shows the procedure of how revenue is recorded in financial statements. it is different from one accounting concept to another concept. For instance, on the cash accounting principle, revenue is recorded in the Financial Statements at the period cash is received. What is accrual accounting principles, the revenues are recognized in the financial statements when the transaction occurs.

Difference between Realizing and Recognizing Revenue?

In accounting, realizing revenue is when the income is received while recognizing revenue recording it when it is earned. In our example, we record revenue in June, although we will receive it in July. When we earn the income that is the point we realize it.

Revenue Recognition Principles

  • Identify the client contract.
  • Identify the commitments in the client contract.
  • Determine the exchange.
  • Allocate the exchange value as per the presentation commitments in the agreement.
  • Recognize income when the presentation commitments are met.

Matching Principle

The matching principle states that expenses incurred in the businesses must be recorded as it generates revenues. Expenses are costs that are incurred in order to generate accrued revenue. From the word matching, https://smallbusiness.chron.com/two-concepts-used-basis-accrualaccounting-37771.html#:~:text=Two%20concepts%2C%20or%20principles%2C%20that,principle%20and%20the%20matching%20principle. requires that revenues and expenses should match at the same time. For instance, if the sales of the company by the end of the month of June are $100,000, and the sales representatives are offered 10% every month then the company will pay the $10,000 commission next July. In June the commission expense should be recognized in the income statement as per the matching principle. Matching principles refer to matching earned revenues with the incurred expenses. Matched earned revenues and incurred expenses are used in the financial statement to determine the company’s net income for a certain period. Revenues Earned –  Incurred expenses=Net profit Besides commissions, there are other matching principles examples:

  • Depreciation
  • Wages
  • Employee bonuses

What Are the Benefits of Matching Principle?

  • Consistency in financial statements
  • Proper recognition of profits- matching principle Recognizes expenses at the right time thus avoiding distortion of financial statements
  • Asset distribution

Cash accounting method

Under cash basis accounting, firms record revenues and expenses in the income statements when they receive payments. The matching concept does not apply in cash basis accounting. For instance, when the firm uses the cash basis accounting method, the commission would be recorded in July (in the month they were paid) rather than June (the month they were incurred).

Differences between Accrual Accounting and Cash Accounting principle.

  • The main difference between https://accounting-simplified.com/financial-accounting/accounting-concepts-and-principles/accrual-concept.htmlis the timing in which incomes and costs are recorded.
  • In accrual accounting, revenues are recognized as earned while in cash accounting, revenues are recognized when cash is received.
  • Expenses on an accrual basis are recognized when incurred while in cash basis, expenses are recognized when the cash payments are received.
  • Large businesses mostly use accrual accounting basis while small businesses prefer cash accounting method.
  • In accrual, accounting taxes are paid with money that has not been received while in cash accounting taxes are paid with money that has been received

Advantages of Accrual Accounting:

  • It’s a preferred strategy for generally accepted accounting principles (GAAP). The Generally Accepted Accounting Principles set out by the Financial Accounting Standards Board prefer it over cash accounting because it produces accurate financial statements.
  • It gives an exact image of the flow of income for the business. Numerous business transactions happen over a period of time.
  • Investors like accrual accounting. A business that utilizes accrual accounting is regularly seen as more lasting and then organizations that use cash accounting.

Disadvantages of accrual accounting

  • It is more complicated-accrual accounting that requires a professional and experienced accountant to avoid inaccuracy.
  • It is not time-saving-accrual accounting requires monthly recordings to avoid inaccuracy. This therefore will require a lot of time in preparing financial statements monthly.

Should a small business use cash or accrual accounting? https://www.irs.gov/ (IRS) recommends a cash accounting method than accrual accounting to be used by small business accounting that does not possess inventories.

FAQ

Why accrual accounting is best for managing cash flow?

Managing cash flow is an indispensable process that all businesses must do. When companies have good cash flow management, this ensures that they will have money available for any future needs. We must recall that accrual accounting registers income and in particular accrued expense, at the time in which the legal right to receive a payment or the requirement to effectuate a payment emerges. Applying the accrual basis method allows users to understand the cash inflow and cash outflow which can be reasonably expectable in a given financial accounting period, and to schedule their cash management in that same way. Moreover, it is indeed the best for running a cash flow statement, since all changes in the cash balances can be clearly visible for all users.

How to switch from cash to accrual accounting?

Switching from cash to accrual accounting is a big step for any company, although it is not an easy step, it is worth it. Usually, in small businesses, these changes happen, as if an owner of the business wishes to prosper he needs this type of change, not simple but necessary as it takes a series of steps to achieve it. First, starting with the bookkeeping work, the books have to be reflected in the accrual method, submit the paperwork to the local tax authority, and then take care of the other tasks. In these other tasks, it is necessary to; subtract cash payments, add monthly expenses, add accounts receivable, add accrued expense, add a prepaid expense, subtract cash receipts and subtract prepayments from clients. In addition, it is recommended to use accounting software for better management control of gross receipts, cash basis income, accounts receivable, or also to be aware of a deferred expense and deferred revenue.

What are the treatments for accruals in the following year?

Firms report all adjustments of income and expense items that have actually been earned or incurred during the year at the end of the accounting period. These adjustments have not yet been recorded. This is done by means of general ledger entries, and the subsidiaries’ sales and purchase histories are not affected at all. Each company also runs a series of postings to account for anticipated costs or receipts. Moreover, standardizing entries always involve an expense or revenue account and a balance sheet account. To sum up, every business must add up the total income and costs accumulated throughout the preceding tax year over the subsequent period. At the beginning of the new year, year-end changes are reversed so as to prevent double counting.

Does the size of a company make a difference in cash basis & accrual basis accounting?

Whether there can be a difference between small and large companies on a cash basis and accrual basis accounting. Small businesses tend to use cash accounting more as it is simpler, more understandable, and easier to execute. However, cash accounting is not as negative and it always starts with something, it is not a bad option to use for a small business. Large companies are forced to use accrual accounting, without it they cannot move forward with a large amount of information they receive and need to analyze. Nevertheless, the most recommendable for any size of one business is accrual accounting, if a business aspires to prosper and hit the next level, it needs to make the change since it provides accurate information giving a better idea of the financial situation through where a company is running.

Why is important to constantly keep track of your cash flow?

The cash flow is the vital tool in a business that supports the control of income and expenses, in that way it allows us to face the daily obligations and to measure the funds with which the entity has. To positively use it in a company is to be updated with the cash flow, the information it can provide is quite vital to be constantly reviewed. The importance of this comes as reviewing the cash flow followed is like a precautionary method since it is possible to find or to prevent all types of threats like the delays, payments no anticipated, or the excess of purchases. To keep track of all this type of information and review it daily is incredible, monitoring and detailing expenses not only detect threats, but it also helps to propose and organize new budgets.