If you’re involved in the finance field, you’ve likely heard of accrual accounting.But some people unfamiliar with the term might wonder what is accounting accrual and how does it impact businesses? Our team at Founder’s CPA will explore this topic and provide a breakdown of what you need to know.
The definition of accrual accounting
Accrual accounting is a financial accounting method allowing companies to record revenue prior to receiving payment for the sold goods or services. As the expenses are incurred, they’re recorded. This means that the earned revenue and expenses that a business incurs are entered into their journal no matter when the money is received.
Many times, accrual accounting is compared to cash basis of accounting; in this method revenue is recorded only when the goods and services are paid for.
How it works
In terms of what is accounting accrual, the general concept is that entries are made when a good or service is provided versus when the payment is made or received. If there are debts or payments due, entries are also created.
It combines the current and future cash outflows and inflows to provide businesses with a more comprehensive and accurate picture of their existing and long-term finances. It follows the matching principle stating that revenues and expenses should be recorded within the same period.
The International Financial Reporting Standard (IRFS) encourages this accounting method. Because of this, it has become the standard accounting practice for most companies outside of individuals and exceptionally small businesses.
How to qualify for accrual accounting
If a larger company has an average gross receipt of revenues over $25 million over the previous three years, they are required to use the accrual method for accounting. In the case that a company doesn’t meet the average revenue requirement, they may choose to move forward with the cash basis or accrual accounting method.
For companies that carry inventory or make sales on credit, they are required to use accrual accounting regardless of what their size or revenue is.
What are the benefits?
As we mentioned, this method provides a more accurate overview of the company’s condition. They will have instant feedback on what their expected cash outflows and inflows are which helps them oversee and manage their resources and create a plan for the future. On the downside, it is relatively complex and expensive to implement.
Accrual accounting vs. cash accounting
On the opposite end of the spectrum is cash accounting. With this method, transactions are only recognized when there’s a cash exchange. Cash basis and accrual accounting are also different in the way and time that transactions are entered.
Accrual accounting: Key takeaways
In this method, payments and expenses are credited or debited when incurred or earned. It uses double-entry accounting, meaning there are usually two accounts used for transactions.
If you’re interested in learning more about this topic or you’re in need of accounting, tax and CFO services, Founder’s CPA is here to help. We’re located in West Loop, Chicago but we work with clients across the country. Get in touch to take advantage of our free 15-minute consultations!
