Accrual accounting is a method in accounting that helps the company to calculate the revenue before collecting it in cash for goods and services that were sold and expenses that the entity paid for them. The different types of accrual accounts include accounts receivable, accounts payable, accrued interest and accrued tax liabilities.
For example, the transactions are recorded even when the cash has not yet been received. There are two types of accounting methods: Accrual and cash basis of accounting.
Functioning of accrual accounting
The basic foundation of accrual accounting says that the transaction will be matched with revenues to expenses in the books following the matching principle of accounting on the current time of transaction or exchange regardless of whether the payment is received or not. This helps the inflows and outflows of the current period to the expected outflows and inflows of the current period which provides a more succinct picture of the financial positions.
Advantages of accrual accounting
The accrual accounting method gives a better picture of the condition of the company. However, the complexity involved in this makes it quite tedious and expensive to implement. This method came into being when the need for more accurate financial information emerged. Many businesses sell on credit, and without the information of these transactions, the real financial picture cannot be presented. And with the usage of accrual accounting, firms acquire feedback on their expected inflows or outflow of the month or year.
Cash accounting vs. accrual accounting
The basic difference between cash accounting and accrual accounting is that the former only records the cash transaction where actual money has been exchanged while the latter takes into account both the cash and non-cash transactions.
Types of accrual accounts
The different types of accrual accounts include accounts receivable, accounts payable, accrued interest and accrued tax liabilities.
Accounts payable are the short-term debts that the company has to pay to the suppliers and the vendors before actually paying them. With accrual accounting, if an expense is made by the company, this debt will be added to the balance sheet and the form of an expense in the income statement.
Does the IRS prefer accrual accounting for the companies?
The IRS does not regulate the type of specific accounting that the company can use, but it has limitations that affect the type of accounting method that can be implemented. For instance, a corporation is not allowed to use the cash method (except the S corporation) where the average annual gross receipts are more than $26 million in 2021 and more than $27 million in 2022. In such a situation, the IRS will require the same corporation to change to the accounting method.
Modified accrual accounting
Modified accrual accounting is a hybrid method based on cash and accrual accounting. Public companies rarely use it as it does not comply with the rules in the Generally Accepted Accounting Principles (GAAP). However, it is extensively used and recognized by government agencies.
Example
An appliance store sells one of its refrigerators to the customer on credit. According to the agreement, the payment for the same can be received at any tentative time in the future. As per the accrual accounting method being used by the company, this transaction will be recorded as an accrued revenue for the sale and not wait for the future when the payment is set to be received.
Furthermore, this method says that the cash method is not an accurate way to record transactions, because the cash to be received is certain, as the services have already been provided. In conclusion, the accrual accounting method is more concise and preferable to the cash method of accounting.
