Accrual accounting is a fundamental principle of financial reporting. It aims to match revenues with expenses when they are incurred, regardless of when cash is exchanged. This method provides a more accurate representation of a company's financial position over a specific period. Let us have a closer look at some important principles:
Principles |
Meaning |
When to recognise revenue? |
Revenue is recognised when it is earned, regardless of when payment is received |
When to recognise expenses? |
Expenses are recognised when they are incurred, regardless of when cash is paid. |
Dividing the business life |
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The appropriate matching |
The expenses incurred in an accounting period must be matched with the revenues they helped to generate. |
Why use accrual accounting in your business
Accurate financial reporting
- Books of accounts based on the accrual concept provide a more accurate representation of a company's financial position and performance by matching revenues with expenses in the period in which they occur.
Assists in future projections
- Following accrual accounting, individuals can understand both:
- What do they owe, and
- What do they expect to earn in the future
- This understanding helps in the effective preparation of future financial reports and the precise recognition of financial trends.
Compliance and transparency
- Accrual accounting also ensures compliance with Generally Accepted Accounting Principles (GAAP).
- It is one of the three fundamental accounting assumptions and helps in the preparation of legally compliant and accepted books of accounts.
How to use accrual accounting in your business
The accrual concept in accounting proposes to record income and spending when they happen, regardless of when money changes hands. Let us see in simple steps how to use accrual accounting:
Step I: Identify revenue streams
The first step is to identify the various sources of revenue generated by your business. This commonly includes:
- Sales of goods
- Services rendered
- Interest income
- Royalties, etc.
Step II: Follow the recognition criteria
Recognise revenue only when the following two main criteria are met:
Revenue is earned |
Revenue is realisable |
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Step III: Identification of expenses
Businesses incur a variety of expenses when generating revenue and operating the business. These expenses commonly include:
- Costs of goods sold (COGS)
- Salaries
- Rent
- Utilities
- Depreciation, etc.
Step IV: Follow the recognition criteria
Recognise the expenses when the goods or services are consumed or used up in the process of generating revenue. This recognition criteria is based on the accrual concept and ensures that expenses are matched with the related revenues in the same accounting period.
Step V: Recording incomes and expenses
After correct identification and recognition of incomes and expenses, now is the time to record them using double-entry accounting principles. Following that, every recorded transaction will have a two-fold impact (debit and credit), as shown in the table below:
Recording incomes |
Recording expenses |
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Some common accrual journal entries
Accrual journal entries are used to record revenues and expenses following the principles of accrual accounting. Let us understand some common entries:
Accrued revenue
- Suppose that a consulting firm provides services to M/s ABC Ltd. in December but will invoice in January.
- The firm records the revenue earned in December by:
- Debiting (increasing) the account of M/s ABC Ltd. and
- Crediting (increasing) the “sales” account
Accrued expenses
- Suppose that a company receives goods from M/s XYZ Ltd. in October but will not pay the bill until December.
- The company records the expenses incurred in October by:
- Debiting (increasing) the “purchase” account and
- Crediting (increasing) the M/s XYZ Ltd account
Deferred revenue
- Consider a scenario where a customer pays for a year-long subscription in advance in December, but the services will be delivered evenly over the following year.
- The company records the payment received in December by:
- Debiting (increasing) a revenue account (say cash or bank) and
- Crediting (increasing) a liability account, such as unearned revenue
- As the services are provided each month, the liability decreases.
- The revenue is recognised periodically by:
- Debiting (increasing) the unearned revenue account and
- Crediting (increasing) a revenue account
Deferred expenses
- Let us assume a business pays for insurance coverage for the upcoming year in December but will not benefit from the coverage until the following year.
- The company records the payment made in December by:
- Debiting (increasing) an expense account, such as prepaid insurance and
- Crediting (decreasing) a cash account
- As each month passes, the prepaid insurance account is gradually expensed by:
- Debiting (increasing) an insurance expense account and
- Crediting (decreasing) the prepaid insurance account
Conclusion
Accrual accounting brings many benefits to businesses. It helps make financial reports more accurate by matching revenues and expenses at the right times. This makes it easier to decide where to spend money and how to grow the company.
The accrual concept in accounting states that expenses and incomes should be recognised in the period in which they occur and not when actual cash is realised or paid. By preparing books of accounts following the accrual concept, you not only remain compliant with GAAP but also make smart future business projections.
