Accrual Basis Accounting
Accrual basis accounting is a financial method used by companies to record revenue before receiving payments for either goods or services sold. Companies are also able to record the expenses incurred prior to the company paying for them.
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This provides a benefit to companies because they can recognize their financial status regardless of when cash transactions occur. Another popular accounting method is cash accounting where the revenue is only accounted for when the cash transaction has occurred for the items being sold. Accrual Basis Accounting follows a matching principle which states that revenues and expenses should be recognized in the same period.
Other than individuals and small businesses, accrual accounting is the standard accounting practice for most companies. The Internal Revenue Service (IRS) allows businesses that qualify to choose their preferred method of accounting. The IRS allows those companies to choose the accounting method that they prefer if the revenue of that company is below the specific threshold that has been set by the IRS. In addition, the IRS does not require a specific method of accounting for businesses. However, it imposes limitations that impact what accounting method a company can use.
While the accrual method does provide an accurate idea of a company's current financial situation, the complexity of the process behind it makes it to be an expensive investment. The background of the accrual basis accounting method originated from business transactions that got increasingly complex over time. Another benefit of accrual accounting is that firms have the opportunity to receive immediate feedback on their cash flow situation which makes it easier for companies to manage their financial situation in various ways.
Cash accounting is a similar concept to accrual accounting in that cash accounting recognizes transactions only when the exchange is in the form of cash. However, companies that carry inventory or make sales on credit typically use accrual accounting. In addition, there are different types of accrual accounts. The most common accounts include payable, accounts receivable, goodwill, accrued interest earned, and accrued tax liabilities. The debt a company incurs when it receives goods or services from its vendors before it has paid for them is considered accounts payable.
An alternative account method that combines accrual accounting and cash basis accounting is considered modified accrual accounting. Most public companies steer away from modified accrual accounting because it does not comply with the generally accepted accounting principles also known as GAAP.