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The accrual method in accounting
How can the accrual method in accounting improve people, teams, or organisational effectiveness?
Contents
There are two basic ways of keeping the accounts for a business.
Business accounts can be prepared on a cash basis or an accrual basis. Cash accounting records income and expenditure when money changes hands. Accrual accounting records economic activity when revenue is earned or an expense is incurred, even when the associated cash arrives or leaves later. Small organisations and personal finances often use cash accounting; larger organisations generally require accrual information.
When to use it
- Use accrual accounts to understand the economic performance of a business over a reporting period.
- Use the distinction to explain why reported profit and cash flow are not the same.
Origins
Accrual accounting developed gradually alongside double-entry bookkeeping, periodic reporting and long-lived business organisations. Luca Pacioli’s 1494 description of Venetian bookkeeping is an important milestone in the documentation of double entry, though not a single invention of the modern accrual method. The Dutch East India Company, chartered in 1602, helped create a need for accounts covering continuing operations rather than one self-contained voyage at a time. Periodic measurement, asset valuation and the matching of revenues with related expenses evolved through later accounting practice and standards.
What it is
Accrual accounting recognises a transaction according to the underlying activity. Revenue is recorded when it is earned and expenses when resources are consumed or obligations arise, subject to the applicable accounting rules. Cash may be collected or paid in another period.
Cash accounting is simpler: a purchase appears when payment is made and a sale when cash is received. That timing can obscure operating performance. Accrual accounting instead creates receivables for earned but uncollected revenue, payables for obligations not yet paid, inventory for resources not yet consumed and depreciation for the use of long-lived assets.
| Cash basis | Accrual basis |
|---|---|
| Revenues are recorded when cash is received. | Revenues are recorded when earned, regardless of when cash is collected, even if customers take a long time to pay. |
| Expenses are recorded when cash is paid for them. | Expenses are recorded when products or services are being produced, regardless of when cash was paid for them. |
| The profit and loss statement and balance sheet reflect when there are cash inflows and outflows, and may not be a good guide for how profitable the firm is. The advantage is that one can track the firm’s ability to manage its cash from period to period. | Financial statements accurately show whether a firm is profitable or not because revenues and expenses are recorded when incurred. |
| Typically used for smaller companies and not-for-profit organisations, where the timing of cash inflows and outflows are a primary concern. | Used by medium to large firms that have more complex operations, need debt (loans, lines of credit) and report frequently to shareholders. |
Matching activity to the appropriate period helps managers assess margins, collection performance and use of supplier credit. It also means that a profitable business can face a cash shortage, or that strong cash receipts can coexist with weak underlying performance.
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