Companies using accrual accounting report revenues when they earn them and expenses when they incur them. Cash flows that follow from these events may occur at other times.
Accrual accounting is the practice of accounting for revenues in the period the firm earns them, and for expenses in the period the firm incurs them. Under accrual accounting, for instance, sellers record a sale as revenue earned even if the customer has not yet paid. Until the customer pays, the seller carries the revenue earnings as either Accrued revenues or Accounts receivable.
Accrual accounting is standard, normal practice for the overwhelming majority of businesses, large and small, across industries, worldwide. Accrual accounting contrasts with cash accounting (cash basis accounting), which records only cash receipts and cash payments.
Choice of Accounting System Impacts Operations and Reporting
At first hearing, the differences between accrual accounting and cash systems may seem minor or unimportant. However, once the accounting system role is better understood, it is clear that the choice of system has a profound influence on operations and reporting. Choosing one system or the other impacts the way the company bills its customers, receives payment, pays its bills, conducts budgeting and planning, and reports to owners, regulators, and tax authorities. The section below How Do Firms Use Accrual Accounting at Work illustrates some of these points."
Explaining Accrual Accounting in Context
This article further explains the nature of accrual accounting. Sections below highlight differences between cash accounting and accrual accounting and reasons for choosing one accounting system over the other. Explanations are in context with accrual-related terms including the following:
- What is accrual accounting?
- Who uses accrual accounting and who does not?
- Transactions appearing only in accrual accounting.
- Example: Sale transaction and Account receivable from the seller's viewpoint.
- Example: Sale transaction and Account payable from the buyer's viewpoint.
- Accrual accounting vs. cash basis accounting: Advantages and disadvantages.
- How do firms use "two sets of books" to manage cash?
Business firms in private industry
When a new company is set up, owners establish several characteristics of the accounting system the company will use.
- They define the company's fiscal year (or financial year). The fiscal year will serve as the organizing basis of financial budgeting, planning, and reporting.
- They decide the nature of the company's accounting system: Firms must choose either accrual accounting, cash accounting, or a hybrid combination of these approaches.
- The firm starting up must choose the accounting system, fiscal year, and registration class. They specify these features of company set up, along with the class of registration when the company officially registers in a government jurisdiction. Several registration classes are normally available:
- Companies may start as public companies with an initial public stock offering.
- When investor groups fund the startup, the firm may begin operations as a privately held company. Privately held firms can, of course, choose to "go public" later.
- Still other registration categories are available for single-owner shops, services, partnerships, professional practices, farm businesses, and other kinds of small businesses.
Some Small Firms Are Free to Choose Cash Basis Accounting
Most of the latter-named company classes are free to choose either accrual accounting, cash accounting, or a combination system. Even those who can choose between systems, however, often choose accrual accounting, no doubt because of several built-in advantages absent in cash accounting (see the discussion below on advantages and disadvantages).
Government regulators and tax authorities in most countries, however, require certain companies to use accrual accounting, only, for reporting purposes.
- Companies that pay taxes separately from the owners must file earnings reports based on accrual accounting. (In US Tax Code terms, these are "C" corporations").
- Public companies (those that sell shares of stock to the public) must use accrual accounting for reporting to regulatory bodies and when sending the Annual Report to Shareholders.
Accrual Accounting is Mandatory for Public Companies
Public companies must use "strict" accrual accounting for reporting because regulators and tax authorities mandate reports that conform to the country's Generally Accepted Accounting Principles (GAAP). And, for public companies in private industry, GAAP supports accrual accounting but not cash basis accounting. This mandate is a near-universal rule everywhere, unlikely to reverse in the foreseeable future.
Note that in 2017, GAAP in most countries is moving toward conformance with standards from the International Accounting Standards Board (IASB) and its oversight body, the International Financial Reporting StandardsFoundation (IFRS). The IASB and IFRS require the use of accrual accounting, only, for reporting.
Government and non-profit organizations
Incidentally, GAAP for government and non-profit organizations differs from GAAP for companies in business. As a result, these organizations are often free to choose between cash accounting, modified cash accounting, or accrual accounting for reporting purposes. Nevertheless, there is a worldwide trend towards accrual accounting for these organizations.
Strict cash basis accounting has in view only two kinds of events:
- Firstly, cash flowing into the business (revenues).
- Secondly, cash flowing out of the business (expenses).
In accrual accounting, however, the events of record are account transactions. An account transaction is an impact on the balance in one of the company's accounts.
To better understand the nature of accrual accounting, understand first that each company's accounting system starts with a chart of accounts. This chart is simply as a list—the complete list—of the company's accounts. The chart of accounts for even a small business may very well include a hundred.
Five Account Categories
Every account in the chart, moreover, belongs to one of five account categories as Exhibit 1 shows:
|Account Category||Debit (DR) Entry||Credit (CR) Entry|
|1. Asset account||Increases (adds to) account balance||Decreases (subtracts from) account balance|
|2. Liability account||Decreases (subtracts from) account balance||Increases (adds to) account balance|
|3. Equity account||Decreases (subtracts from) account balance||Increases (adds to) account balance|
|4. Revenue account||Decreases (subtracts from) account balance||Increases (adds to) account balance|
|5. Expense account||Increases (adds to) account balance||Decreases (subtracts from) account balance|
|Exhibit 1. The accrual-base accounting system includes five categories of accounts. A debit transaction increases the balance in Asset accounts and Expense accounts. A credit transaction increases the balance in Liability accounts, Equity accounts, and Revenue accounts.|
Note also that only two kinds of impact are possible on any account—a debit or a credit. Note also that debits and credits have different impacts in different account categories.
The example transactions in sections below represent the mainstay actions in accrual accounting. Note especially, that most of these are completely "off the books"—non-existent— in cash accounting. Examples below show how transactions enter the accounting system as journal entries. The same transactions will post later to the firm's general ledger. And, account balances will ultimately appear in the firm's end-of-period financial reports.
All of the accrual terms above—including Accounts receivable and Accounts payable—are conventions made necessary by the accrual accounting matching concept. Matching means that firms record revenues in the period they earn them, along with the expenses they incur in earning the same revenues. Matching revenues and expenses in this way ensures that firms report the period's profits accurately.
Every Sale Includes Two Events--For Buyer and Seller Alike.
Accrual accounting recognizes certain realities in business and commerce. Firstly, for both the buyer and the seller, a complete sale includes two events:
- The seller delivers purchased goods or service.
- The buyer pays.
Both parts of the sale may coincide, as in retail shopping. Or, either part may precede the other with a time lapse between them. For instance:
- Delivery occurs first when the customer buys using seller-issued credit.
- Payment occurs first when a buyer prepays for service delivery, as with floor space rental payments due before occupancy begins.
The time lapse between events can be as short as a few seconds, as with retail shopping. Or the time between events can be weeks or even months. The longer time between events occurs, for example, when one business buys from another using seller-issued credit. In such cases, the seller delivers goods to the customer and then sends an invoice (bill) to the buyer. Invoices in such cases normally state payment terms, such as "Net 30 days." This statement means the buyer has a legal obligation to make cash payment 30 days or less after receiving the invoice.
Criteria for Earning and Owing
One tenet of accrual accounting is the belief that a company's actual financial situation changes more so when it earns revenues or incurs expenses. By the same tenet, the exchange of cash payment between buyer and seller has less meaning for the company's financial position. As a result, accrual accounting has very clear criteria for specifying the moment the seller earns as well as the moment that the customer owes (incurs an expense).
- Earning coincides with service or goods delivery. The seller earns revenues when and only when the seller delivers purchased goods or services.
- Owing coincides with receipt—or consumption—of goods or services. The tenant renting floor space does not incur (owe) the rental expense until the tenant occupies the space, even though the landlord may have required prepayment.
In accrual accounting, earning or owing by these definitions put the sales transaction "on the books." Actual cash payment and cash receipt are entirely different events.
Recording Both Parts of the Sales Transaction
To match earnings and expenses to comply with the matching concept, both the seller and the buyer record the first part of the sale event, as it occurs. with two journal entries. Example journal entries of this kind appear above in Exhibits 1, 3, and 4.
Later, when part 2 of the sale occurs, buyer and seller each make another pair of journal entries, such as Exhibits 2, 5 and 6 show.
Exhibit 2 summarizes the possible accounting results from a sale, after just one part of the two-part sale transaction takes place.
Transaction Part One...
|When Buyer Pays Before
|When Seller Delivers
Before Buyer Pays
|The Seller Has ...||Unearned Revenue
|The Buyer Has ...||Deferred Expense
|Exhibit 2. Accrual accounting results after only one part of the sale transaction event takes place. The two or three terms in each cell are essentially interchangeable.|
Prepayment: Buyers pay for goods or services before the seller delivers
The prepayment situation occurs when customers pay before receiving goods or services. That is the unearned revenue situation, the subject of this article.
- Prepayment for the seller: Unearned revenues
The seller claims unearned revenues (or deferred revenues) as revenues received for goods or services the seller has not yet.
The seller records unearned revenues as liabilities until delivery of the goods or services takes place. After delivery, the funds become revenue earnings for the seller.
- Prepayment for the buyer: Deferred expenses
The buyer claims deferred expenses (or prepaid expenses or deferred charges) when paying for services or goods before delivery. The buyer carries deferred expenses as assets until receiving or consuming the services.
- A one-year subscription to a computer back up service, paid in advance, is a deferred expense.
- When firms pay taxes in advance of due date, they create prepaid expense.
- For more on the deferred expense concept, see Deferred Expense.
Deferred Payment: The Seller Delivers Goods or Services Before the Buyer Pays
A deferred payment situation results when the seller delivers goods or services before the customer pays.
- Deferred payment for the seller: Accrued revenues
In the deferred payment situation, the seller who delivers goods or services before the buyer pays, records accrued revenues (or accrued assets, unrealized revenues, or accrued sales).
Sellers may post accrued revenues in an asset account, such as Accounts receivable until the customer pays cash. Then, the seller credits (reduces) Accounts receivable, while at the same time debiting (increasing) another asset account, Cash.
- From the buyer's viewpoint: Accrued expense
Buyers post accrued expenses (or accrued liabilities, or deferred expense) in their books, registering their debt for goods and services purchased but not yet paid for.
- When employers owe their employees salaries or wages for work completed, but not paid them yet, the employer has an accrued expense.
- Interest payable for a bank loan can be an accrued expense. The borrower first enters them into the journal as a liability until the customer pays, at which time the customer debits the liability account (reduces account balance) and at the same time credits (decreases) ab asset account such as cash.
- Firms first enter Accrued expenses
in the journal as liabilities until they pay them.
- Firms debit (reduce) a liability account when they pay.
- At the same time, they credit (decrease) an asset account such as Cash.
Exhibit 3, below, has the results for buyer and seller after the second sales transaction event.
|After Both Parts of the Sales
|When Buyer Pays Before
|When Seller Delivers
Before Buyer Pays
|The Seller Has ...||Sales Revenue Earnings||Sales Revenue Earnings
|The Buyer Has ...||Expenses Paid||Expenses Paid|
|Exhibit 3. Accrual accounting results after the second sales transaction event.|
Transaction Accounting for the Seller and the Buyer
Consider a sale transaction for a manufacturer selling goods to another company. On 15 August, Achilles Corporation sells and ships goods to the buyer, Apollo Company. Along with the goods, the seller sends an invoice for $65,200 marked "Net 30." Apollo must pay this bill in 30 days or less. At sale closing, the seller records the sales revenues and new value in Accounts receivable as follows:
Journal for Fiscal Year 20YY
| NNN Accounts receivable|
NNN Sales revenues
The debit transaction for $65,200 impacts Achilles' Accounts receivable, an asset category account. A debit increases the balance in asset accounts. At the same time, the seller credits (increases) the balance in Sales revenues, a revenue category account.
The sale transaction is now "on the books" even though the buyer has not yet paid.
Seller and Buyer Have a Creditor-Debtor Relationship
While the bill is unpaid, the accounting systems of both companies recognize that seller and buyer have a creditor-debtor relationship. Achilles holds $65,200 in Accounts receivable, while Apollo carries another $65,200 in its Accounts payable (a liability account). What happens next depends on whether or not Apollo ever pays Achilles.
How Does the Seller Recognize Actual Payment?
If the buyer makes a cash payment in 30 days or less, say, on 1 September, the seller preserves the $65,200 sale value by moving it from one asset account to another. Here, the seller debits (increases) a Cash account and credits (decreases) Accounts receivable, as follows:
Journal for Fiscal Year 20YY
| NNN Cash|
NNN Accounts receivable
In this way, accrual accounting keeps the sale transaction "on the books" while Achilles waits for payment. As a result, Achilles will add $65,200 to "Sales revenues" on its next Income statement, while adding the same amount to "Current assets" on Achilles end-of-period Balance sheet.
What Happens if the Buyer Never Pays?
Assume now, however, that Apollo does not pay, ever. Instead, Apollo declares bankruptcy and goes into liquidation. On 15 October, Apollo's liquidator sends an unpleasant message to Achilles. Achilles learns that asset liquidation will not generate funds enough to cover the debt. The firm must now recognize, formally, that it will never recover the $65,200 debt. Achilles must, in other words, register a bad-debt write-off.
In that case, Achilles can begin the write-off process by recognizing a Bad debt expense and an Allowance for doubtful accounts, with these transactions:
Journal for Fiscal Year 20YY
| NNN Bad debt expense|
NNN Allowance for doubtful accounts
Achilles makes two account transactions at the same time. First, Achilles debits (increases) "Bad debt expense" by $65,200. Second, Achilles credits (increases) "Allowance for doubtful accounts the same amount. Note, incidentally, that "Allowance for doubtful accounts" is an asset category account, but it is also a contra asset account. As a result, this account balance increases with a credit transaction—just opposite to the impact in a normal asset account.
Later, nearer the end of the accounting period, when Achilles is completely certain the customer will never be pay, Achilles completes the write-off process with these transactions.
Journal for Fiscal Year 20YY
| NNN Allowance for doubtful accounts|
NNN Accounts Receivable
In this case, with the write-off, Achilles' next Income statement still reflects the $65,200 sale. Achilles did achieve the sale, after all. However, just under the Income statement revenue figures appears a "Bad debt expense" item for $65,200." This item brings the appropriate profit and margin figures below.
For the buyer in the above example, accrual accounting also keeps the sale on the books from the moment the sale closes. In this case, Apollo bought goods from Achilles, expecting not to pay immediately, but to receive an invoice "Net 30" for $62,500. Assume that Apollo expects to add these goods to its merchandise inventory, and ultimately sell them. In that case, Apollo could record the sale as follows:
Journal for Fiscal Year 20YY
| NNN Merchandise Inventory|
NNN Accounts payable
"Merchandise inventory" is an asset account, increased by a debit transaction. "Accounts payable" is a liability (debt) category account, increased by a credit transaction.
If Apollo actually did send a cash payment of $65,200 on 1 September, Apollo's accrual accounting system could include these transactions:
Journal for Fiscal Year 20YY
| NNN Accounts Payable|
The liability account, "Accounts payable" is reduced by a debit transaction. "Cash" is an asset account, reduced by a credit transaction.
In managing finances, companies in business must simultaneously pay attention to two different considerations:
- The timing and management of revenues, costs, and expenses is critical for reporting earnings, determining taxes, and declaring dividends.
- The timing and management of cash flow is critical for meeting obligations and business needs: Paying employees, paying interest on loans or bonds, or investing in new product development or infrastructure upgrades, for instance.
It should be no surprise that for most businesses, accrual accounting is the better option for managing revenues, costs, and expenses, while cash basis accounting is in several ways better suited for managing cash flows. The distinctions between cash accounting and accrual accounting can be sharpened further with a brief review of some advantages and some disadvantages to each approach. The final section of this article describes ways some companies attempt to benefit from the advantages of both system
Advantages to Accrual Accounting:
- Describes accurately sales transactions that are only partially completed, e.g.. where customers have received goods and services but not yet paid for them. Such situations are invisible to cash accounting.
- Makes possible the application of the matching concept, the idea that firms report revenues in the same period as the expenses that brought them.
- Has the advantage of immediacy. Because the firm records sales revenues then they earn them and expenses when they incur them, the company knows immediately what it can expect in both categories.
- Has one form of built-in error-checking. Accrual accounting is implemented with double-entry bookkeeping and accounting, in which the sum of total debits must equal the sum of total credits. This relationship is tested every reporting quarter and year during a trial balance period.
- Conforms to GAAP in most countries, as well as IFRS / IASB standards.
Disadvantages to Accrual Accounting:
- Accrual accounting is not well suited to managing cash flow for budgeting and planning purposes. The benefit of "immediacy" is also a disadvantage concerning cash flow management. Cash flow management is not "immediate" under accrual accounting.
- The understanding and using accrual accounting requires an understanding of double entry accounting and bookkeeping. Many business people lack this understanding. For most companies, the use of accrual accounting requires professional accountants.
Advantages to Cash Basis Accounting:
- Immediacy: Whereas cash accounting does not readily give immediate information on earnings and expenses, cash accounting does give immediacy to cash inflows and outflows.
- Cash basis accounting is simpler than accrual accounting. Those without a background in accounting or bookkeeping can readily learn and apply cash basis accounting. And, this approach is understandable to a much wider audience than accrual accounting.
- Many small companies can use the cash basis approach without involving a professional bookkeeper or accountant.
- The cash basis approach does not require complex accounting software. Firms can easily create and maintain a cash basis single entry system in a written notebook or a very simple spreadsheet.
Disadvantages to Cash Basis Accounting:
- Cash basis accounting does not conform to GAAP in almost all countries. That means that public companies cannot use cash basis account for reporting to shareholders or tax authorities.
- Cash basis accounting does not allow for tracking actual dates of sales and purchases. This limitation is not a problem for businesses that always receive payment immediately when they make a sale, and always pay immediately when they incur an expense. This limitation does create a problem for companies that sell on credit, or invoice customers after a sale for payment some period later.
- Under cash basis accounting, firms do not record partial payments by customers as such, and therefore the cash accounting Balance sheet may not reflect all payments due.
For some business people, the phrase "two sets of books" brings to mind an illegal practice. Some less-than-fully-honest firms do hide revenues and earnings from government regulators and tax authorities by keeping two sets of books.
- Firstly, they use the official accounting system books for recording revenues and earnings they do intend to report.
- Secondly, they keep a second set of books—with real revenues and earnings—for internal management and control.
There is nothing inherently illegal, however, about using two, three, or more different accounting systems simultaneously. The law merely requires that the system that reports to shareholders, regulators, and tax authorities conforms to GAAP and is accurate. For public companies, this almost always means that the accounting system for reporting must be an accrual accounting system.
Some companies, for instance, use accrual accounting to meet reporting requirements but keep cash accounts for budgeting and planning purposes. Other companies use so-called "modified accrual accounting" and "modified cash accounting" approaches, in addition to the accrual accounting system they use for reporting. These "modified" approaches attempt to blend and capture the benefits of both "strict" accounting methods.
Several accounting software systems currently on the market their capability to "keep" several different accounting systems simultaneously