Definition:
Accrual accounting is a method of accounting that recognizes revenues and expenses when they are earned or incurred, regardless of when the cash is received or paid. This is in contrast to cash-basis accounting, which recognizes revenues and expenses only when cash is received or paid.
Key principles of accrual accounting:
- Revenue recognition: Revenues are recognized when earned, even if cash is not received immediately. For example, if a company sells a product on credit, the revenue is recognized when the product is delivered, even if the customer doesn’t pay until later.
- Expense recognition: Expenses are recognized when incurred, even if cash is not paid immediately. For example, if a company receives a utility bill but doesn’t pay it until the following month, the expense is recognized in the month it was incurred.
Why is accrual accounting important?
- Accurate financial picture: Accrual accounting provides a more accurate picture of a company’s financial performance by matching revenues and expenses in the same period.
- Comparability: Accrual accounting makes it easier to compare the financial performance of different companies.
- Decision-making: Accrual accounting provides more relevant information for decision-making.
Example:
A company sells a product on credit for $100 in December. The customer pays for the product in January of the following year. Under accrual accounting, the revenue is recognized in December when the product is delivered. Under cash-basis accounting, the revenue would not be recognized until January when the cash is received.
In essence, accrual accounting is a more accurate and informative method of accounting that helps businesses make better decisions and understand their financial performance.
