Accrual accounting is an accounting method by which companies recognize revenue when earned and record expenses when incurred, regardless of the time of cash. In other words, a company can recognize revenues and expenses even though it has not received or paid money.
Why you should know about accrual accounting
Most companies use accrual accounting for financial reporting. This method provides more useful and reliable financial information. The company recognizes revenue when earned and expenses when occur. Hence, this accounting method provides a fairer picture of the company’s performance.
But remember, in accrual accounting, profits are not the same as the amount of money the company makes. That’s because companies can recognize revenues and expenses even though money hasn’t changed hands.
So, you might find a company is profitable, but poor cash. Why? It is because most of the company’s money is still in the customer (unpaid). Or, the company yet recognized expenses for inputs delivered in the future.
Difference between cash accounting and accrual accounting
Accrual accounting is the antithesis of cash-based accounting. The difference between the two is how the company reports its revenue and expense.
In cash accounting, a company recognizes revenue when it has received cash payments. Also, it records expenses when it has paid cash. In other words, the recognition of the revenue and expenses is only when money changes hands.
In contrast, the accrual method is independent of the flow of money. The company could recognize revenue or expense, although it has not yet received or paid cash.
Let’s take a simple example. A company sold Rp100 products to customers on March 15. Instead of paying it in cash, customers defer payment until April 30.
Under the accrual method, the company will recognize the revenue of Rp100 on March 30, even though the company has not received cash. Under the double-entry principle, on March 30, the company will also recognize trade receivables of Rp100. In this case, assets and equity each increase by Rp100, so that the accounting equation remains in balance.
Then, on April 20, the company recorded an increase in cash and a decrease in trade receivables, amounting to Rp100 each.
In contrast, in the cash method, the company does not recognize revenue as of March 30. And, it will record Rp100 in revenue on April 30.
Advantages and disadvantages of accrual basis accounting
Accrual accounting gives a more accurate picture of the company’s current performance. That’s because companies recognize revenue when they have provided goods or services. Also, the company recognizes an expense when it has received products or services from suppliers.
But, unlike the cash method, it does not give us a better picture of the funds we have. In the accrual method, money might yet go into your account. But, you already claim it as revenue because you have provided goods or services. And you can collect it at any time.
Likewise, you might pay cash to your supplier for future service. Your money has decreased, but you don’t have to recognize it as an expense.
As a result, your net profit will be higher than the money you have.
Also, in preparing financial statements, the accrual method requires some estimation. For example, you need to estimate uncollectible receivables to report trade receivables. Also, in reporting fixed assets, you need to estimate depreciation.
Such estimation is not 100% correct. Thus, readers of financial statements cannot have the same high level of confidence as when using the cash accounting method.
Also, the accrual method allows companies to manipulate net income by recognizing revenue earlier or later. Or, companies do it by speeding up or delaying the recognition of expenses.
The next weakness is related to complexity. The accrual method is expensive to implement. It requires more resources in preparing financial statements than cash accounting.
Four types of accrual accounts
Four types of accrual accounts in a financial statement are:
- Unearned revenue or deferred revenue arises when the company yet provides goods or services to customers but has received cash payments. Before delivering products, it will report unearned revenue in the liabilities and cash in the assets. Then, after customers received products or services, it records revenue and eliminates unearned revenue.
- Accrued revenue arises when a company has sold goods or provided services, but yet receives cash payments. An example is a trade receivable. Before payment, the company recognizes trade receivables in the asset and revenue in the income statement. After receiving payment, the company eliminates trade receivables and reports cash increases.
- Prepaid expenses arise when the company has paid cash, but yet receives goods or services from suppliers. Before receiving products or services, it reports prepaid expenses as assets and recognizes the expenses. After receiving the goods, it recognizes the expense on the income statement. At the same time, it eliminates the prepaid expense account.
- Accrued expenses arise when the company receives goods or services before pays the cash. Accrued expense accounts appear in the liability, and at the same time, the company recognizes an expense in the income statement. After paying cash, the company eliminates the accrued expense account. And, the company’s cash position (in the assets section) decreases by an equal amount.