Accrual Accounting: Working, Benefits, and Examples

Accrual accounting stands as a pillar of financial transparency and clarity amongst other accounting methods, like the cash basis accounting method. In this business world, accurate accounting ushered by accrual basis bookkeeping creates an unshakeable bedrock upon which successful financial operations are built.

Unlike cash basis accounting, this form of accounting looks beyond cash transactions and offers a more comprehensive view of the organization’s financial health and performance. Moreover, accrual accounting is the only acceptable method, as prescribed by SEC and GAAP, for all the 3300 public companies on NASDAQ.

 

In this blog, we uncomplicate the accrual based accounting processes, understand its benefits, explore its working principle, and offer real-world examples to illustrate its practical application. In addition, we talk about how accrual accounting software is improving the accounting standards for fast-scaling businesses.

What is Accrual Based Accounting?

The act of recording expenses and revenues on an accrual basis, i.e., when they are generated instead of when the transaction takes place, is called accrual accounting. 

Looking deeper, the accrual concept in accounting combines the fundamental of the matching principle and revenue recognition, providing a more accurate picture. 

The matching principle establishes that all expenses should be recorded in the same period as the revenue generated by them. Similarly, revenue recognition posits that revenue should be recorded when it is realized to be earned. These records keep the financial statements with high-value actions taken during that time. 

By adopting the accrual method of accounting, businesses can achieve a clearer understanding of the intricate relationship between revenue and expenses, enabling them to gain deeper insights into their profitability. Moreover, this method accurately depicts a company’s assets and liabilities on its balance sheet. 

Such benefits have led to the widespread adoption of accrual basis accounting, the sole method permitted under the Generally Accepted Accounting Principles (GAAP) and mandated by the Securities and Exchange Commission (SEC) for publicly traded companies.

Other accounting methods include cash accounting and modified accrual accounting. 

What are the Reasons to Use the Accrual Method of Accounting?

From compliance with the GAAP framework to offering insights for better strategic planning, here’s a closer look at the 5 reasons companies should consider accrual accounting methods.

1. Remain GAAP Compliant

The accrual based method of accounting serves as a crucial tool for businesses seeking to maintain compliance with the General Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). As the standard framework for financial reporting in the United States, GAAP and IFRS provide guidelines and regulations that ensure consistency, transparency, and comparability in financial statements. 

Adopting accrual based accounting helps companies align their practices with GAAP and IFRS requirements, instilling trust among investors, stakeholders, and regulatory bodies. In fact, SEC makes it compulsory for all publicly-listed companies to follow accrual basis accounting.

2. Better Financial Picture

Using the accrual method offers a clearer and more comprehensive financial picture than the cash basis accounting method. Recording revenues and expenses in the same reporting period as they are earned or incurred, aka accounts receivable, rather than when cash payments and incomes (transactions) occur, offers a more accurate representation of the business’s financial health and performance. This is not the case with cash basis accounting.

This is different from the cash basis method. How? An accrual based method allows for a deeper understanding of revenue generation, expense patterns, and overall profitability. This empowers decision-makers to make informed choices based on a holistic view of their organization’s financial landscape.

3. Improve Accuracy

Accrual accounting strives to capture the true financial position of a business by recognizing revenues and expenses in the accounting period they occur. This approach eliminates the distortions that can arise in the cash accounting method, where cash inflows and outflows may not align with the actual economic activities of the business.

In other words, accrual accounting provides a more reliable representation of a company’s financial performance than cash method by accurately reflecting the timing and magnitude of financial transactions and recording accounts receivable.

4. Obtain Credit

Businesses must demonstrate their stability and creditworthiness when seeking external funding or credit. Accrual accounting bolsters your position by showcasing a more comprehensive and reliable financial picture than the cash method. 

Lenders and creditors prefer the accrual method as it captures the full extent of a company’s assets, liabilities, and revenue streams and gives them a clearer understanding of the borrower’s financial health and repayment capacity. This increased transparency enhances the chances of securing favorable loan terms and credit opportunities, which might be challenging in cash accounting.

5. Plan for Growth 

Unlike cash accounting, accrual accounting provides valuable insights for strategic decision-making and future planning. With a detailed understanding of revenue streams and expense patterns, businesses can identify areas of growth potential, allocate resources efficiently, and optimize their operational strategies. 

Accurate financial data from accrual accounting enables businesses to forecast cash flows, project profitability, and set realistic goals, laying the groundwork for sustainable growth and expansion.

How Does Accrual Accounting Work?

As mentioned earlier, companies following the accrual accounting framework recognize revenue when it is earned and expenses when they are incurred. More often than not, accrual accounting works on the idea of recording transactions before the money exchanges hands. Consequently, the original bank balance and the amount on the balance sheet seldom match, which is quite unlikely in cash accounting.

But how do the accounting and finance departments reconcile these accrued and incurred transactions?

Well, accountants use financial placeholders for these events. Accounts receivables and payables are the most widely recognized placeholders to record transactions. The former is part of an asset account representing revenue that is earned but yet to be received. And the latter can reflect expenses incurred but yet to be paid, aka accrued expense/ accounts payable. 

What are the Benefits of Accrual Accounting?

Adopting the accrual basis accounting method (one of the major accounting methods) offers many compelling benefits to companies, not in cash accounting. Investors, upper management, accountants, finance professionals, and stakeholders enjoy the benefits of accrual basis accounting.

1. Accurate Forecasting and Budgeting 

Accrual accounting provides a solid financial planning, forecasting, and budgeting foundation. Capturing revenues and expenses as they are earned or incurred enables businesses to develop more reliable projections of the cash flow, estimate future revenue streams, and allocate resources more effectively when compared to cash accounting. 

This method enables organizations to set realistic financial goals, plan for contingencies, and optimize their budgeting processes. Accurate financial planning increases the likelihood of achieving financial targets and supports long-term stability and growth.

2. Improved Performance Evaluation

With accrual based accounting, businesses gain deeper insights into their profitability. Matching expenses to the corresponding revenue facilitates a more accurate assessment of the relationship between costs and income. 

It empowers businesses to identify revenue sources that yield higher margins, evaluate the effectiveness of cost control measures, and pinpoint areas for operational improvement. This comprehensive performance evaluation can guide strategic decision-making and drive sustainable growth.

3. Efficient Tax Planning

Accrual based accounting optimizes tax planning strategies for businesses so they pay taxes accurately and in accordance with the tax payments regulation laid out by the Internal Revenue Service (IRS). Companies leverage the delay between the expenses incurred and when they are actually paid to enjoy deductions and purchase credits available to them during the tax year.

Accrual accounting helps businesses reduce taxable income and liabilities by aligning the revenue generated with recurring or significant business expenditures. Accurate accrual based financial statements also provide a solid basis for tax reporting and compliance, reducing the risk of errors or discrepancies during tax audits.

4. Better Business Valuation

Accrual based accounting plays a crucial role in accurately assessing the value of a business. It allows potential investors, lenders, or buyers to evaluate the worth of a company more accurately by providing a comprehensive view of revenue streams, expenses, and financial performance. 

Accrual accounting provides a reliable basis for calculating key financial ratios, such as the return on investment (ROI) and the debt-to-equity ratio, which are essential factors in determining the value and attractiveness of a business to external parties.

5. Streamlined Audit Workflows

Accrual accounting ensures that financial statements align with the relevant accounting standards, reducing the risk of errors or misinterpretations. This method also facilitates compliance with regulatory requirements, as it adheres to established frameworks such as GAAP, making the auditing and reporting processes smoother and more efficient. By maintaining accurate and comprehensive financial records, companies are better prepared for financial audits, both internal and external.

Examples of Accrual Accounting

While the concept of accrual accounting is highly beneficial to businesses, it can confuse some of us. For a better understanding of what is the accrual method, let’s look at two examples of accrual accounting for each of their fundamentals, revenue recognition and expense matching.

1. Revenue Recognition 

Let’s consider a software development company that signs a contract with a client to build a custom software solution. According to the terms of the agreement, the company will receive $50,000 upon completing the project, which is expected to take six months.

In accrual accounting, revenue would be recognized gradually as the company fulfills its obligations and satisfies the performance criteria outlined in the contract. For instance, if, after three months, the company has completed 50% of the project, it would recognize $25,000 as revenue on its financial statements. This recognition reflects the value created and delivered to the client during that period.

Recognizing revenue incrementally, rather than waiting for the full payment upon project completion, enables the company to accurately represent its financial performance over time. This approach aligns with the matching principle, ensuring that revenue is recorded in the same period as the corresponding expenses incurred to generate it.

2. Expense Matching

Say, a manufacturing company that purchases raw materials to produce its goods. The company orders $10,000 worth of materials from its supplier, and the goods are delivered immediately. However, the supplier extends a credit period of 30 days for payment.

In accrual accounting, the company would recognize the expense of the raw materials immediately upon receipt, even though the actual payment will occur in the future. This allows the company to reflect the consumption of resources and match it with the revenue generated when the goods are sold.

The financial statements accurately reflect the company’s current financial position and the true cost of producing its goods by immediately recognizing the expenses at the time of receipt. This approach provides a more comprehensive view of the company’s profitability and ensures that expenses are properly matched with the corresponding revenue.

How Does Accounting Software Help with Accrual Based Accounting?

While accrual based accounting is highly beneficial for businesses, doing all of it manually can leave you exhausted and prone to errors. That’s where online accounting software come in. 

Accounting software empowers businesses to implement accrual based accounting effectively. It automates processes, enables accurate accrual tracking, simplifies financial statement preparation, provides real-time insights, and ensures compliance and audit readiness.

Accounting software leverages advanced technology to offer several key benefits that support the effective implementation of accrual based accounting principles.

1. Automated Recording 

Accounting automation software automates the recording of transactions, ensuring that revenues and expenses are captured accurately and promptly. This eliminates manual data entry errors and saves time, allowing businesses to maintain an updated record of financial activities.

2. Accrual Tracking 

Accounting software enables businesses to track and manage accruals more efficiently. It provides functionalities to record and monitor accrued revenues and expenses, ensuring they are appropriately recognized in the correct accounting period.

3. Financial Statement Preparation 

Accrual based accounting software simplifies the preparation of financial statements by automatically generating income, balance sheets, and cash flow statements based on the accrual method. It, thus, provides a comprehensive and accurate view of a company’s financial position.

4. Real-time Insights 

Accounting software offers real-time reporting and analysis capabilities, allowing businesses to access up-to-date financial information and insights. This helps stakeholders make informed decisions, monitor performance, and identify trends that impact profitability.

5. Audit Readiness 

Accrual based accounting software helps ensure compliance with accounting standards, such as GAAP. It facilitates accurate record-keeping, simplifies the auditing process, and provides an audit trail, increasing transparency and reducing the risk of errors or inconsistencies.

As you can see, having accounting software capable of dispatching accrual accounting duties makes your accounting department incredibly productive. But we understand how painful it is to find the perfect software. You can, thus, refer to our exhaustive list of the 20 best accounting software in India. 

Wrapping Up

Accrual based accounting is vital for businesses, providing a comprehensive financial perspective and enabling informed decision-making. By adopting this method, companies can build a solid foundation for success, ensuring accurate reporting, compliance, and strategic financial management. 

But this stands true only when you optimally leverage accrual based accounting; that’s why you need robust accounting software. You’ll then be able to easily streamline these processes and access real-time insights into their financial landscape. Hopefully, we’ve answered the question of what is accrual accounting method while offering unmatched insights about its working application.