A method of bookkeeping that records revenues as they are earned and expenses as they are incurred.
Accrual accounting is a method of bookkeeping that records revenues as they are earned and expenses as they are incurred. Its purpose is to provide a solid and transparent framework to record transactions.
Accrual accounting varies from cash accounting, which records each transaction when cash changes hands. Cash accounting is easier for businesses to implement because it simply involves recording transactions when there is an actual inflow or outflow of money.
Accrual accounting, on the other hand, is a bit trickier. This is because the accrual method essentially is a set of guidelines that need to be followed to correctly prepare statements.
The rules of accrual accounting serve as the basis on which transactions are recorded, these rules must be followed without a single error to perfect the financial statements of a business.
Those guidelines all derive from the same principle: all entries must be recorded as they are earned or incurred. While that may seem like a little too much jargon, we could explain it with examples, which will be laid out throughout the text.
Accrual accounting is used mainly because:
- Improves transparency and consistency.
- Can be summed up in a framework that is easy to replicate.
- Having an accounting standard helps when analyzing or comparing business.
Now, let us dive deeper into each of these points.
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Transparency and consistency
Suppose Company A uses an accrual basis of accounting. On May 2nd the company sold $1,000 worth of goods to Joe. Assume also that Joe is going to pay for it using a credit card, which has a payment term of 30 days.
Importantly, the company purchased the inputs necessary to produce those goods from its supplier on April 10th and it cost them $450.
If the company used cash accounting, an expense of $450 would be recorded for the month of April, and a revenue of $1,000 would be recorded only after the payment term of the credit card had passed, this leaves us with an issue.
It may be possible to keep track of a few of these transactions, but beyond a certain point, it would be really difficult, both to understand and also to implement because we are not interested only in recording the transaction but also in measuring profitability and other important metrics.
Cash accounting would be misleading since our profitability measure would be subject to payment terms on both revenue and expense side,, which would not represent the real financials of the firm.
While it may be easier than the accrual method, cash accounting lacks consistency. Suppose we had a large store and 100,000 transactions to record. If we only use cash accounting, it would be very difficult to account for the profitability of the business.
Now, since accrual accounting is built upon a set of guidelines and rules, it is much easier to interpret a large book of entries with this method, since we only have to remember the rules which further helps us in recording the actual transactions.
Not only is it easier to understand when performing analysis but also easier to record.
To better understand how these metrics are categorized in the balance sheet, we must first understand how an account is distinguished between being an asset or a liability.
- If an account represents an event or transaction that will grant us future economic benefits, it is an asset.
- If it represents a future economic obligation/sacrifice/payment, it is said to be a liability
Main accrual accounting frameworks
The foundation for the accrual framework is the matching principle. The principle states that an expense in producing a given good must be recorded in the same period as the revenue for that particular good.
All guidelines for accrual accounting are derived from this principle, such as recording for depreciation, accrued revenues/expenses, deferred revenues, deferred taxes, and so on.
With that in mind, one can start to realize just how important accrual accounting really is. Without a standard in place, businesses would just record those entries however they may please, which would create a lot of confusion.
Accrual accounting is adopted by both IFRS and GAAP accounting standards. GAAP and IFRS are the two major reporting frameworks that public companies must abide by.
The U.S. GAAP is overseen by FASB (Financial Accounting Standards Board) which puts in place the guidelines issued by the SEC.
IFRS is overseen by the IASB (International Accounting Standards Board), since IFRS is a multi-national framework, its reinforcement is under the responsibility of local authorities.
In addition to the matching principle, the accrual framework also relies on the revenue recognition principle.
The revenue recognition principle mainly states that revenue must be recorded on the statements as it is earned and not when cash changes hands.
Back in our example, if our company sold $1,000 worth of goods to Joe in May but he only pays us in June, we would record our revenue in May, as it was when we closed the transaction.
The bedrock for the revenue recognition principle is the definition of what is a transaction.
According to accounting theory, a transaction is effectively carried out when there's an exchange of economic benefit. In our case, if we didn't get paid immediately, we had already provided a benefit to our customer by selling him $1,000 in goods.
The terminology "economic benefit" has some critical implications. For instance, suppose our company sells $1,000 worth of goods that will be shipped to a customer in another country, and we only ship them 5 days after we receive payment. What should the accounting treatment be?
Well, we must keep in mind that revenue must only be recorded when there's an exchange of economic benefit, that basically means that we can only recognize it on our book when we provide a benefit for our customer, in that case, that means to ship our goods.
Let's lay out a timeline to simplify the process.
The company purchases the goods ($10)
We sell the goods on credit (15$)
We ship the goods to our customer
The credit payment comes in
Considering this timeline, how do you think we should record our revenue? One might be tempted to answer that we should record it when we sell the item, which further means that the recording will take place on 02/04.
However, that answer is wrong. The reason why it is wrong is that we only provide economic benefit for our customers once we ship them the goods.
Moreover, the reason why we recognize revenue when we ship the items and not when it is in fact delivered is to make the process uniform by accounting for only the factors that we can control.
What that means is, that the company has control over the date it ships the products, but not on the actual date the product will be delivered.
Now, let us apply the matching principle to the same example above.
The company bought the inputs from the supplier on 01/25, this means that under cash accounting the expense would be recorded at that very moment.
Under the accrual basis, however, we must remember that the costs of a given good must be incurred as the good generates revenue.
This means that we would record the expenses for purchasing the inputs only when we recognize the revenue for selling the final product.
These guidelines help us put in place a very reliable and sound reporting system, where everyone involved can keep track of what is happening with the company's financials.
Together, both accrual and revenue recognition principles form a solid base for businesses and investors to keep track of what comes in and out of their businesses.
It is important to note that both these concepts work together and both are interdependent.
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Diving deeper into revenue recognition
Since revenue recognition takes into account timing differences between the entry of cash and the actual delivery of goods, the impact of this standard will be greater in companies that have big exposure to these factors.
For instance, for companies that operate with long-term contracts, such as manufacturers of large equipment, the revenue recognition process will be far different from that of a retail company.
The same applies to businesses that agree to provide services or goods over a period of time on upfront payment, such as subscription services.
As the company carries out its operations, it will also incur expenses. Under accrual accounting, the recognition of expenses must follow the matching principle.
With the same understanding, the costs for producing a good or providing a service can only be recorded once the revenue from the same is recognized.
Suppose that a manufacturer of tractors has a contract to provide equipment to a farm over a period of 5 years. Further, it purchases all the inputs it will need beforehand. The contract states that one tractor will be delivered every quarter (3 months).
Now let's go through a timeline of the contract.
The company closes the deal to provide 8 tractors to a soy farm over 2 years
The customer pays upfront the whole value of the contract ( $5 million)
All necessary inputs are sourced
The first tractor is delivered
The second tractor is delivered
As in the previous example, the timing differences are of paramount importance here. Should the revenue be recognized all at once when the company receives the full payment? Or should it be spread out over the course of the contract? And what about the expenses?
Applying the revenue recognition principle here has a greater impact on the financial statements than in the previous example. The reason is simple. Since the company must recognize revenue as it is earned, it will effectively consider each delivery as a stand-alone revenue.
Also, the expenses will be treated accordingly. The costs for producing each tractor will be recorded in the statement in the period the tractor was delivered.
For investors, understanding the revenue recognition principle is key to fully understanding a company's filings and financials. Suppose that we work for an asset manager seeking to buy a position in a plane manufacturer.
Once we start to go through the filings, if we don't properly understand the implications of the accrual framework, we would be at risk of missing a potential investment opportunity or, even worse, misinterpreting a bad call as a good one.
While revenue recognition and the matching principle impact all items on the balance sheet relating to revenue and expenses, they play a far bigger role and also give rise to several accounting entries, the main ones being:
- Accrual expenses
- Deferred revenues
- Prepaid expenses
All three are essentially items that would be recorded on the income statement if it were not for the accrual framework. The main idea is to keep them in-store in the balance sheet and, once they can be recognized, record them in the income statement.
We can now go through each of them and see what they mean.
Accrued expenses mean to account for expenses that have been incurred over a given period of time but not yet actually paid for, this is the premise on which the accrual concept operates.
They are recorded on the balance sheet under the liabilities section. The reason why they are considered a liability is that we will have to pay for them in the future, so it represents a future economic liability.
Had it been the other way around (providing us with future economic benefit) we would have recorded it as an asset.
Examples of accrued expenses include salaries and bonuses that have already been granted and will be paid at a future date.
Supplier costs may also be considered if they comply with the definition of being built over time. However, this kind of expense is usually compiled under accounts payable.
One may think that accrued expenses are somewhat similar to accounts payable.
The major difference between the two is that accounts payable simply represent a bill that is due for payment on a certain date.
On the other hand, accrued expenses are built (accrued) over a given period of time. The amount owed evolves over that time frame, whereas in accounts payable, once we make the purchase we know the exact amount we owe to the creditor.
While they are recorded as a liability on the balance sheet, accrued expenses also appear on the income statement, since they have already been incurred. They may appear under COGS (cost of goods sold) or operating expenses, such as SG&A.
For instance, let's assume a company pays $100,000 in salaries for the whole year.
From a journal entry perspective, the way this would be carried out is as follows:
Income Statement (SG&A) $100,000
Balance Sheet (Accrued expenses) $100,000
It is important to note, however, that once the payment has actually been done, the accrued expense account will be debited, and its balance will go to zero.
Deferred revenues arise whenever a company receives money for a good/service not yet delivered. They are a part of the current liability account since it implies that the company has the obligation to provide those goods/services.
A good example of deferred revenues is gift cards.
When companies sell gift cards to their customers, they are essentially committing to providing goods/services in the longer term. It means that in the current statements, the company must account for that future obligation.
In that case, the value the card was sold at would be accounted for under deferred revenue.
Another example would be a company that sells goods blended with services. For instance, the company sells laptops. To go with them, they also sell 1-year at-home service if the equipment presents malfunctioning.
Apart from the revenue that the laptop provides, the company will recognize the 1-year service as well. This would be included under the deferred revenue account usually found in the balance sheet.
Suppose the price of the laptop is $1,000. The journal entries would be as follows:
Balance Sheet: Cash: $1,000
Balance Sheet: Deferred Revenue: $1,000
Once the company actually fulfills the obligation, the revenue can then be recorded in the income statement, since at that time there will be no obligation pending against the laptop sold.
Whenever a company pays in advance for items that represent expenses in the future, a prepaid expense arises. It is recorded as an asset on the balance sheet because it provides the company with future economic benefits.
Examples of such expenses are - prepaid rent, utility bills, insurance policies, etc.
A company may often pay utility bills for the next six-twelve months, as the utility company may be offering a subsidized rate for prepayment or the company may possess surplus cash at that point in time.
It would be recorded on the balance sheet by debiting the prepaid expenses account under current assets.
Under accrual accounting, we can only record an expense when its associated benefit is received. So only after the 6 months, would we record the utility bill in the income statement
In fact, no. Since it demands a thorough and well-organized bookkeeping system, it may require a certain amount of capital expenditures. Depending on the size of the business, that may be a problem.
Moreover, for small businesses, the framework may make things unnecessarily complicated, as the business will have to comply with a whole new accounting framework. In such cases, the enterprise may stick with cash accounting.
Accounting is all about consistency and transparency.
Just imagine how hard it would be for investors, analysts, and accountants to understand financial statements if each company just followed the most convenient way to record transactions.
Cash accounting, while may seem easy, gives room to inconsistencies since it makes it hard to measure profitability, as already discussed.
These factors warrant a common approach. The next question would be: Which framework to use? It's simple, let's build one based on the main accounting principles. That is exactly the rationale behind accrued accounting.
Deferred taxes arising from mismatches between tax and the accrual accounting framework.
- If the company pays more in taxes than it should have paid under accrual accounting, deferred tax assets are created.
- If the company pays less in taxes than it should have paid under accrual accounting, deferred tax liabilities are created.
For instance, when it comes to depreciating assets, if the tax reporting guideline instructs the company to depreciate a larger amount than the accounting standard does, the company will reduce its income before taxes and effectively pay fewer taxes in the current period. The same goes the other way.
The accounting framework adopted by each country/jurisdiction has to reflect its culture and generally accepted practices. GAAP was established in the US in the aftermath of the Great Depression, seeking to ensure transparency and overall good practices in financial markets.
On the other hand, the IFRS framework was developed over a lengthy period of time, in a process that encompassed several countries. This feature makes them both different in nature. The IFRS has to take into account different accounting habits and, to an extent, cultures. Whereas GAAP was tailored for the US.
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Researched and authored by Lucas
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