The accrual accounting method is a method of managing the accounting of a business in which transactions are recorded at the time they take place even if an exchange of assets has not taken place between the entities involved in the transaction, i.e. payment for the goods sold or services provided was not yet received by the seller and wan not yet made by the buyer. This method is based on the basic accounting principle called the matching principle, i.e. when it is necessary to match revenue with expenses incurred to earn such revenue.
How is the Accrual Accounting Method Used?
The basis of the accrual method of accounting dictates that as soon as a document, such as a billing statement or sales receipt, which supports the assumption that a debit or credit transaction has taken place, the accountant makes an entry into the appropriate accounts to represent the transaction. The accountant would not, for example, wait until the cash is collected to record a sale as a credit in the accounts, but would record it as soon as the contract was made to support the title to get cash in the future. Of course, if cash or other property is exchanged between the entities involved in the transaction at the time the transaction initially takes place, such as a purchase made in a retail store, then the transaction would be recorded at that time regardless of the accounting method being applied.
What are the Benefits of Using the Accrual Accounting Method?
With the accrual accounting method, since liabilities are accounted for as soon as they is a legal basis for them to occur, it is less likely that a business will fail to allocate assets to cover the liabilities due to an accounting error. Also, since using accrual accounting means that assets, liabilities and revenues are recorded in chronological order, accrual accounting allows transactions to be evaluated easily and efficiently. In addition the accrual method of accounting provides more accurate financial position of the business. However, the accrual method does require that more entries are made into the accounts and since transactions are recorded despite whether cash for goods sold or services provided is received or not, in case customers fail to pay their debts, such debts will have to be recorded as losses. This is a good practice, as financial statements will indicate quality of accounts receivable and losses incurred on sales to non-paying customers.
We can conclude that this method of accounting is more widely used and recommended accounting method.
Example of the Accrual Accounting Method
The company ABC on May 2, 2009 signs an agreement with the company XYZ to sell 1000 chairs. The chairs are delivered to the warehouse of the company XYZ on May 3, 2009 and the ownership title to the chairs is transferred to this company at the delivery time. Payment for the chairs will be made within 30 days from the delivery date. Applying accrual accounting method company ABC in its books will record the transaction on May 3, 2009, when the chairs were delivered to the customer, i.e. recording sales revenue and accounts receivable from the company XYZ, reduce value of inventory by the cost on inventory sold and reflect cost of sales as the expenses related to the sales income of chairs, despite the payment for the goods will be made later.
Applying the same method of accounting, company XYZ will record purchase of chairs in its books, i.e. increasing inventory value and recording liability (accounts payable) to the company ABC.
Thus both companies will have to record this transaction on the date, when ownership title to the goods was transferred from the seller to the buyer, despite the date when actual payment will be made.