Accrual Accounting

The Accrual Accounting principle states that revenue is recognized when the sale is completed,regardless of whether it is a cash or credit sale. Expenses are matched and recognized concurrently with the corresponding revenue irrespective of when the expense is paid. Businesses keep a tab on accruals to ensure the tracking of their receivables and payables.

Various types of accrual transactions can be found in the book of businesses but according to the accrual accounting basics, they fall under either expense accruals or revenue accruals. Accounting on an accrual basis gives an apt financial overview of the company and provides a detailed image of the receivables and payables in real time.

1. Accrual accounting is a method of accounting where revenue and/or expenses are recorded when a transaction occurs or when a payment is made. 
2. Most common examples of Accrual accounting are Sales on credit, purchase on credit, rent paid, electricity expense, depreciation, audit fees, etc. 
3. Accrual accounting is used to give a clear picture by showing the real-time happenings of the business. It also helps investors make decisions and judgments about the business’s present and future. 

Accruals in Accounting are the expenses or revenues that have been recorded by the firm but not yet realized. The major reason for using accrual accounting is to get a fair and accurate picture of the business at any given stage. As a key stakeholder of the business, one would want to know where a business stands at any given point in time. They would want to know how a business is doing currently, not what a business is due to receive in the near future. If a company is using the accrual basis of accounting, then as an investor, one can be sure that the company's current affairs are the most accurate.

The accrual accounting method showcases exactly what is happening in the business, not what a business will achieve shortly. For example, if a firm has sold products on credit, it will show the same as sales even if the money is yet to be received.

Moreover, a vital point to note is that it is applicable for relatively medium to large businesses which earn a considerable amount of cash flow during any year.

Let us understand the usage of accrual accounting principles and practical concepts through the points below:

#1 - Accounts Payables

Difference Ltd. has salaries payable of $40,000.

The effect of this transaction would be two-dimensional. That means one needs to record this transaction in two places.

First, it would be recorded as salary expenses in the income statement. And then, it would be treated as a current liability and will be recorded on the company's balance sheet.

Let us now look at a practical example. Below is the snapshot of Colgate's Current Liabilities. We note that Colgate has reported accounts payables of $1,124 million in 2016 and $1,110 million in 2015. Accounts payables primarily consist of salary payables.

source: Colgate SEC Filings

#2 - Prepaid Expenses

Similar Ltd. has prepaid wages of $100,000. How would we treat it as per the accrual basis of accounting?

This transaction is the opposite of the previous example.

First, it will record it as a wage expense in the income statement. It also shall be recorded as prepaid wages under the current assets of the balance sheet.

Below is the snapshot of the Facebook Balance Sheet.  It can be noted that Facebook has reported prepaid expenses of $959 million and $659 million in 2016 and 2015, respectively.

source: Facebook SEC Filings

#3 - Accounts Receivables

Equal Ltd. has total sales of $10 00,000. Out of the total sales, 60% is in cash. How would we treat this transaction under accrual accounting?

Here, 40% of sales are credit sales. But the credit sales will also be treated as sales, and the profit would be generated by including both the cash and credit sales and then deducting the cost of goods sold and the operating expenses.

It is important to note that credit sales would not be accounted if it were cash accounting.

Below is an example from Colgate’s Balance Sheet. We note that Colgate has reported accounts receivables of $1,411 million on $1,427 million in 2016 and 2015, respectively.

source: Colgate SEC Filings

The following section refers to the financials of Amazon. Let us understand the numbers by applying accrual accounting principles:

Here, one can observe that in the Accounts receivables section, the firm has recorded the payments that the firm expects to receive from its customers for the services or the goods delivered. But since this payment is not yet received, there is a credit risk involved as there is an element of uncertainty. Therefore, the firm has also recorded Bad debt or doubtful accounts. It is a good accounting practice and helps remove the ambiguity of the accrual-based revenues.

The Accrual accounting method has its own share of advantages and disadvantages in its application, accounting, and relevance. Let us understand them through a comparison below:

Benefits

• It is a holistic approach: Accrual accounting is a comprehensive system, unlike cash accounting. You would agree that a business is not about cash only. Many aspects should be taken into account. Under the accrual system, we can record all the business's financial transactions (cash and others). We can also create financial statements like the income statement and balance sheet to get a more holistic view of how a company is doing.
• There are almost no discrepancies/errors: Since the financial transaction is immediately recorded as it occurs, there are virtually no chances of discrepancies or inaccuracies. And since everything is recorded all the time, if one wants to do an audit, the information is readily available.
• Accuracy level is higher: Unlike cash accounting, accrual accounting follows a double-entry system. That means one account is debited and another account is credited. As a result, we can see how one account is reduced, and another account has increased. It increases the accuracy level of accounting, and later on, during an audit, things get easier.

Limitations

• Quite complex: Cash accounting is easy to record and easy to maintain. But accrual accounting is complicated to record since every time a financial transaction happens, there should be an entry in the books of accounts. And maintaining the whole accounting system isn’t an easy job as well.
• Holistic but challenging to maintain: A business has different aspects. And if a business is enormous, in a single day, hundreds and thousands of financial transactions need to be recorded under this accounting. Maintaining all of these daily, day after day, isn’t an easy job for an accountant.

This has been a guide to what is Accrual Accounting. We explain the concept with an example, along with the advantages, disadvantages, and concepts. You may also have a look at these articles for enhancing your knowledge in accounting –

• Assets vs Liabilities
• Debit vs Credit in Accounting | Top 7 Differences
• Balance Sheet Format
• Accounting Concepts