key term - Accrual Accounting

Definition

Accrual accounting is a method of accounting that recognizes revenue when it is earned and expenses when they are incurred, regardless of when the actual cash transactions occur. This approach provides a more accurate representation of a company's financial position and performance compared to cash-based accounting.

5 Must Know Facts For Your Next Test

1. Accrual accounting allows for the recognition of revenue when it is earned, even if the cash has not yet been received, and the recognition of expenses when they are incurred, even if the cash has not yet been paid.
2. The balance sheet under accrual accounting includes accounts receivable and accounts payable, which represent money owed to and by the company, respectively.
3. The statement of cash flows under accrual accounting reconciles the net income (from the income statement) with the actual cash inflows and outflows during the period.
4. Accrual accounting provides a more accurate representation of a company's financial performance and position compared to cash-based accounting, as it matches revenue with the associated expenses.
5. Accrual accounting is the standard method used by most businesses and is required for publicly traded companies in order to comply with Generally Accepted Accounting Principles (GAAP).

Review Questions

• Explain how accrual accounting affects the balance sheet, compared to cash-basis accounting.
  • Under accrual accounting, the balance sheet includes accounts receivable (money owed to the company) and accounts payable (money owed by the company), which are not reflected in a cash-basis balance sheet. This provides a more complete picture of the company's financial position, as it includes obligations and claims on resources that have not yet resulted in cash transactions.
• Describe how accrual accounting principles are applied in the preparation of the statement of cash flows.
  • The statement of cash flows under accrual accounting reconciles the net income (from the income statement) with the actual cash inflows and outflows during the period. This involves adjusting for non-cash items, such as depreciation, and changes in working capital accounts, like accounts receivable and accounts payable. These adjustments are necessary to show the true cash impact of the company's operations, investing, and financing activities.
• Evaluate the advantages of accrual accounting over cash-basis accounting in terms of providing a more accurate representation of a company's financial performance.
  • Accrual accounting provides a more accurate representation of a company's financial performance because it matches revenue with the associated expenses, regardless of when the actual cash transactions occur. This allows for the recognition of revenue when it is earned and the recognition of expenses when they are incurred, which gives a better understanding of the company's profitability and resource allocation. Additionally, the inclusion of accounts receivable and accounts payable on the balance sheet provides a more comprehensive view of the company's financial position, enabling better decision-making and financial planning.

Related terms

Cash Basis Accounting:

A method of accounting that records revenue when cash is received and expenses when cash is paid, regardless of when the underlying transaction occurred.

Matching Principle:

The accounting principle that requires expenses to be recognized in the same period as the related revenue, in order to provide a more accurate representation of a company's performance.

Accounts Receivable:

Money owed to a company by its customers for goods or services provided, which are recorded as an asset on the balance sheet under the accrual accounting method.