Accruals make up the basis of the accrual accounting method together with deferrals. The accrual method definition explains how the company’s accountant makes modifications for gained revenue and expenses used even before they are recorded in the company’s general ledger. The meaning of accrual method allows for a financial statement to be correct and inclusive of these revenues and expenses. Like that at the end of an accounting period, the accrued interests are registered in adjusting journal entries. Without these methods of registering each amount, accruals can be overlooked, money lost, or available without explanation. It’s easy to see how accruals impact a company’s balance sheet as non-cash payments, liabilities, and assets are involved.
The accrual method is one of the two basic methods of accounting. Through this method, revenue is considered earned, and expenses are considered incurred regardless of when cash is received or paid. The accrual accounting method is different from cash-based accounting, which records revenues and expenses only when cash is received or paid. There is a third accounting method that is a hybrid of the first two named the modified accrual accounting.
In a company’s balance sheets, the accrual accounting method considers any transaction, whether they are cash-based or through other means. The transactions are recorded, as mentioned above, in an adjusting journal entry as a means to keep track of them.
To simplify the accrual method definition, we can look at the other accounting method for a bit. An uncomplicated method is applied in grocery shopping. You go to the market and buy an apple, pay the apple’s value and get the apple in return. This is the cash accounting method.
The vendor, however, received those apples from a producer. When the transaction was done, let’s say the vendor obtained the fruits without paying for them and will reimburse the producer when the money from selling them is available. There’s a low chance a producer would accept that, but in that case, the transaction would be registered through the accrual method. As the producer did not receive the cash value of the fruits during the transaction, but the fruits are no longer in his possession, that future revenue has to be registered through an adjusting journal entry.
The accrual method became necessary as business transactions increased in complexity. Nowadays, it’s not as simple as buying an apple with cash, well … not in all transactions. Thus, the accrual accounting method is the standard accounting method as it is the only accounting method that respects the generally accepted accounting principles (GAAP), with only small businesses being allowed by the IRS to choose the method they want to use. The reason for that is because the accrual accounting method is more complex and more expensive to implement.
Through accrual accounting, a company is no longer limited to cash transactions. This accounting method makes it possible for a company to determine how much they owe and the amount of cash to be received from transactions that happen at a certain point in time. Cash inflow and outflow are combined with expected cash flows giving a much more accurate image of the financial position of a company. Every transaction is accounted for whether it comes with a current cash flow or a future one, following the matching principle. For each expense, there is a matching revenue, and they should all be recorded in the company’s balance sheet when they occur. In the end, the accrual accounting method clarifies the resources a company has at the end of the accounting period making it easier to plan future transactions or investments.
A rental property owner has a tenant that always pays their rent on time. For an unforeseeable reason, the tenant misses the month of July. If the rental property owner uses the accrual accounting method, they have to register the revenue on the date when it should have registered. Through the accrual method, the revenue is registered during July by an adjusted journal entry as the transaction was done, the tenant used the accommodation.
For expenses, a homeowner that contracts a landscaping company but forgets or is unable to pay on the due date, the accrual method will report an expense for that due date. The cash is still in the homeowner’s pocket. Yet, it is registered through an adjusted journal entry as an expense because the landscaping company provided the service, and the payment is considered an expense on the due date.
The reason for which the accrual accounting method is more accurate is because it takes into account payments when they are due, making it easier to keep track of cash flow. Like that, the rental owner knows that he/she will have that inflow of cash from the renter, and the homeowner knows that an outflow of cash is expected.