What is Accrual Accounting?
There are two basic accounting methods, one is accrual basis and the second is cash basis. Generally, businesses choose one of two accounting methods in their bookkeeping system.
Accrual Accounting calculates the company position and performance by recognizing the economic events. In accrual accounting, transactions are recorded in the accounting book if payment for the particular goods/services has not been received or made. This process is important to evaluate the organization's health and position in financial terms.
It follows the matching principle so that we can recognize the revenue and expenses in the same period of time.
In simple terms - Accrual accounting refers to records of all the transactions even if the payment for the services/goods has not been received by the customer. It is a very appropriate way to measure the company position and health in finance.
Examples To Understanding The Accrual Accounting
Understand accrual accounting with an example: - Suppose you are running a firm and the firm name is XYZ Pvt. Ltd. and you are using the accrual accounting system to maintain your accounting books. If you sell any product/ service on credit, the transaction is recorded in the sale book based on the generated invoice. The transaction is also recorded when we buy the raw material on credit from the supplier.
We record cash, credit, etc. transactions in the accounting books so that we can get a real picture of the company's financial transaction.
How Does Accrual Accounting Work?
Concept of the accrual accounting is that economic events are recognized by matching the expenses and revenue at the time of the transaction occurring if the payment is received or not.This method allows us to combine the current cash inflow and outflow for expecting future cash inflow and outflow, to provide an accurate real picture of the company's financial position. Its relative complexity makes it expensive to implement. This method works better for those companies who offer goods and services on credit and those businesses who take projects and receive the payment after a long period of time.
It gives instant feedback on the cash inflow and outflow so that business owners manage their resources.
Cash Basis Accounting VS Accrual Basis Accounting
Cash Basis Accounting
It recognizes the revenue when the cash is received on the sale and expenses are paid. It does not recognize the receivable and payable accounts.
It is simple to maintain and there is no need to track the receivable and payables accounts. It is very easy to determine when the transaction has occurred and the payment is received in the account or in cash.
The cash method accounting is very helpful and beneficial in terms of tracking how much cash the business has in the current period of time.
In cash basis accounting, we don’t record the transaction until the cash is received or paid, the business income is not taxed until the cash is not in the bank.
Accrual Basis Accounting
In this method, we record the income and expenses transaction in the accounting books rather than payment is made or received. For example - your company sold goods but the payment has not been received. The sold good transaction is recorded in the sale book.
Commonly, businesses use accrual basis accounting rather than cash basis accounting.
This method gives a more realistic idea of income and expenses during a period of time. It provides the financial picture of the company which cash basis accounting does not.
Accrual accounting does not give information about cash flow. In this, the business can appear more profitable but in reality, has an empty account. If we don’t monitor the cash flow in the accrual accounting then we have to face potential harmful consequences.