There are two accounting methods in practice; cash basis and accrual basis of accounting. These two accounting methods are useful for a company to measure their economic positions by recording transactions, regardless of (Accrual Basis) or cash (Cash Basis) when the payment is incurred.
An accrual basis of accounting is one of the two accounting methods that record income and expenses when a transaction occurs. Moreover, the revenue and expense are considered for the same time frame though you haven’t exchanged the cash.
Also read: 7 Differences Explained on Cash Basis vs Accrual Basis
This is not the same as the cash basis of accounting. On a cash basis, the revenue and expenses are recorded only when the cash is exchanged.
Let me make it more simpler for you with an example.
Suppose I have sold my products in bulk to a retailer who now owes me $5000 in the year 2020. The retailer has 30 days time period to pay me, which is the due date in 2021. Now, I have to record this transaction in the tax year of 2020 though I haven’t received the payment. Additionally, this payment due in the tax year 2021 should only be recorded in 2020 because of the transaction incurred in the year 2020.
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How do you Record Expenses on an Accrual Basis Accounting?
Now, the factory in which I produce the products asks me for the rent, and as usual, I pay the rent. In the last month of the financial year 2020, as usual, I pay the rent.
A month later, I receive bills from the electricity and water department. Now, I have 30 days of the time period to pay these bills, which are due in the financial year 2021. Though I am paying for an expense in 2021, I have to record it in the year 2020. I have paid the rent in the year 2020 and have to report it as a liability in the record for the year 2020, which is later adjusted using the entries.
Also read: How to Write a Dispute Letter to Creditor
Why Accrual Basis?
As I have said earlier, there are two types of accounting; Cash basis and Accrual basis accounting. While it is easy to implement a cash basis, it is not accurate and can create a fuss. On the other hand, the accrual basis is more accurate but harder to implement.
Accrual basis is more beneficial during the tax periods as the major focus are –
- What revenues are earned
- What expenses are incurred
Though the money is not exchanged, the accrual basis works on the actual transaction time frame. Moreover, during the accounting period, if a company uses the accrual basis accounting, the expenses are recorded in the income statement, and expenses are reported as a liability, balanced using the adjusting entries.
Also read: What is After Market Order?
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Frequently Asked Questions
On the accrual basis of accounting, the revenue and expenses are recorded regardless of the payment is exchanged.
You record a revenue or expense when a task or transaction such as selling a product is completed, regardless if you have received the payment in the same financial year.
Accrual basis accounting gives a more accurate picture of revenues earned or expenses made in that financial year. It helps you calculate approximately the correct gross revenue and expense of the year and is harder to implement.
Though effective, accrual accounting is not easy to implement. On the other hand, cash basis accounting is easier to implement but is not effective.
Article References
- IRS Publication
- Investopedia – Accrual Accounting
https://www.investopedia.com/terms/a/accrualaccounting.asp - Accounting Coach
https://www.accountingcoach.com/blog/acrrual-basis-accounting
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