Accrual basis definition
/What is the Accrual Basis?
Accrual basis is a method of recording accounting transactions for revenue when earned and expenses when incurred. The accrual basis requires the use of allowances for sales returns, bad debts, and inventory obsolescence, which are in advance of such items actually occurring. An example of accrual basis accounting is to record revenue as soon as the related invoice is issued to the customer.
Advantages of the Accrual Basis
There are multiple advantages associated with operating an accounting system using the accrual basis, which are as follows:
Matches revenue to expenses. A key advantage of the accrual basis is that it matches revenues with related expenses, so that the complete impact of a business transaction can be seen within a single reporting period.
Most realistic performance assessment. An accrual-basis income statement presents the most realistic assessment of the reporting entity’s performance, since it incorporate all relevant revenue and expense line items. This is useful for lenders and creditors, who need a detailed view of an organization’s performance.
Required for audits. Auditors will only certify financial statements if they have been prepared using the accrual basis of accounting. This is mandated by the applicable accounting frameworks.
Disadvantages of the Accrual Basis
A small business may have a difficult time enacting the accrual basis, since it requires some knowledge of accounting systems, and especially of reversing journal entries. Consequently, it can make more sense for a small business to start with the simpler cash basis of accounting, and then switch to the accrual basis after it has increased in size.
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Accrual Basis vs. Cash Basis
The alternative method for recording accounting transactions is the cash basis, where revenues are recorded when the related cash is received, while expenses are recorded when the related supplier invoices are paid for. This approach is simpler than the accrual basis, and so is favored by smaller businesses. However, it can result in lumpy revenue and profit reporting, since it depends on the exact timing of when cash is received or paid out. These timing differences can be intentional, resulting in deliberate delays in cash payouts in order to avoid recognizing expenses in a specific reporting period.
Given these issues, larger organizations prefer to use the accrual basis, which yields more consistent financial reporting and a truer picture of the financial results of a business from month to month.