By DeVry University
December 14, 2022
5 min read
December 14, 2022
5 min read
Accrual accounting is a term you may have heard but its meaning remains a bit murky. Businesses of all types and sizes need to use different accounting methods to track their finances, get a clear picture of their cash flow, compare their financial performance over multiple accounting periods and determine what taxes are owed. Without being familiar with what this term means, it might be hard to see why it’s so important.
In this article, we’ll provide a detailed answer to the question: What is accrual accounting? We will also discuss how it works, its benefits, some of the different types of accruals and how accrual accounting differs from cash basis accounting.
Deferred revenue: Also referred to as unearned revenue, this type of accrual is recorded when a business receives cash before a good is delivered or a service provided. It goes on the balance sheet as a liability because the company is obligated to deliver the goods, or the services, in the future.
Accrued revenue: In this accrual type, the business has delivered the goods or services, but hasn’t yet received payment. Accounts like these are typically seen in long-term projects or loans where milestones are established and met.
Prepaid expenses: This account is created when a company pays up-front for something before the good or service has been provided. It’s an asset account because it shows the company is entitled to receive the goods or services in the future.
Accrued expenses: Also known as accrued liabilities, accrued expenses occur when a company incurs an expense and hasn’t been billed for it yet. In this case, the company has received the merchandise or service and will pay for it in the future and in the meantime the expense is an accrued liability.
By using accrual accounting, companies can look at both current and expected cash flows, providing a much more accurate picture of the organization’s financial health.
Accrual accounting shows underlying business transactions, not just those involving cash. Many transactions may be relatively straightforward, with payment received or made at the time of the transaction. Other transactions, which may be more complex, involve buying and selling on credit. This requires the company to account for monies that will be paid or received in the future.
Accrual-based accounting is likely to be more accurate regarding a company’s assets or liabilities. Adhering strictly to a cash-basis system, a company’s accounting may leave out crucial information regarding unpaid invoices or liabilities, which could cause the omission, however unintentionally, of certain assets.
The timing of when revenues and expenses are recognized can have a major effect on a company’s perceived financial health. One example of this can be found in the construction business, where a company may take on a long-term project and not receive cash payments until the project is completed.
Using the accrual method, a company would benefit from something called the percentage of completion method, in which the construction company mentioned above, for example, would recognize a percentage of revenue and expenses proportionately as the project was completed. In this case, the accrual method would show the prospective lender a more complete picture of the company’s revenue channel.
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