By CFO Brew Staff
less than 3 min read
Definition:
There are two main methods of accounting that businesses can use to account for revenue and expenses in financial statements: accrual accounting and cash basis accounting. Of the two, cash basis is considered simpler, especially for smaller businesses, while accrual accounting provides a more accurate and timely picture of a business’s financial health, especially for larger, more complex organizations.
Although smaller businesses can choose to use cash basis accounting, generally accepted accounting principles (GAAP) as laid out by Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB) require that publicly traded companies and larger organizations use accrual accounting for their financial reporting. The Securities and Exchange Commission, as well as the IRS, also mandate accrual accounting for financial reporting.
How does accrual accounting work?
Accrual accounting is based on the matching principle, which requires that revenues and their related expenses be reported together. This requires that companies use the double entry principle, which pairs assets and liabilities as credits and debits. In other words, every transaction has two sides in the ledger—one account that increases and one account that decreases.
For example, a company receives an order in Q1 for widgets to be delivered in Q3. However, the customer pays for the widgets in advance, in Q1. Under cash basis accounting, that revenue would be recognized immediately, but under accrual basis accounting, the revenue doesn’t get recognized until Q3, when the widgets are delivered to the customer.
Matching the revenue and the expenses gives companies, and investors, a more real-time view of what the company is earning and spending. In the widget example, accrual accounting would show how much the company sold the goods for—the credit—and how much it cost to produce the goods—the debit—at the same time.
