BY CPA Dr. Zipporah Obonyo Nyachwaya
Accrual Accounting Proves to Be an Excellent Methodology for A Company to Manage Debt, Income, And Financial Activity
The main purpose of accounting information is to provide a true and fair view of the economic organization of reporting entities in order to support economic decisions by their stakeholders.
Companies can choose the best method of accounting which is suitable for the preparation of their financial statements.
The available options are accrual basis accounting and cash methods. The term accrual accounting typically has an association with innovations in accounting. These innovations include recognizing economic events in flow reports when they occur and when the related cash receipts and payments change hands. The economic events may directly generate a corresponding or simultaneous cash flow, but in many cases, such as depreciation, revaluations, or impairment, they do not. This draws a thin line between cash and accrual bases…The recording of all stocks of assets and liabilities in balance sheets. Any organization that follows pure cash accounting bases accounts for their cash holdings on the assets side and, possibly, debt on the liability side of their balance sheets. These are often valued at “book value”, or the value at which they were initially acquired or issued. Under accrual accounting, it ensures recognition of all assets and liabilities, including financial assets (such as equities), non-financial assets (such as land and buildings), and liabilities other than debt securities and bonds (such as payment arrears and pension obligations).
Below is more insight of the two accounting methods;
Accrual Accounting
Under this method, revenue is accounted for when it is earned. Unlike the cash method, the accrual method records revenue when a product or service is delivered to a customer with the expectation that money will be paid in the future. In other words, money is accounted for before it’s received. Likewise, expenses for goods and services are recorded before any cash is paid out for them. So, the revenue earned and expenses incurred are entered into the company’s journal regardless of when money changes hands.
Accrual accounting is usually compared to cash basis of accounting, which records revenue when the goods and services are actually paid for, thus the difference being timing of recording the transaction. The accrual method follows the matching principle, which ensures that revenues and expenses should be recognized in the relevant period. Accrual accounting uses the double-entry accounting method. This method allows the current and future cash inflows or outflows to be combined and to give a more accurate picture of a company’s current and long-term finances. Therefore, the accrual-basis accounting method ultimately provides a greater overview of the business’s financial health position, taking far more into account than cash flow or cash on hand. Accrual accounting is encouraged by International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP). As a result, it has become the standard accounting practice for most companies.
This method arose from the increasing complexity of business transactions and a desire for more accurate financial information. The recognition and measurement or valuation of complex transactions, and assets and liabilities (e.g., finance leases, private-public partnerships (PPP), financial instruments, and intangible assets). Selling on credit and projects that provide revenue streams over a long period affect a company’s financial condition at the time of a transaction. Therefore, it makes sense that such events should also be reflected in the financial statements during the same reporting period that these transactions occur.
Cash Basis Accounting
Under this method, revenue is reported on the income statement only when cash is received and expenses are recorded only when cash is paid out. This leads to easier tracking of cash flow of the company, on the contrary it might overstate or understate the health of a company that is cash-rich since it does not recognize accounts receivables and payables. As a result, shareholders, investors and other users of the financial statement might conclude that the company is making a profit when, in reality, the company might be facing financial difficulties or conclude that it is making losses when the company is stable financially. The cash method is typically used by small businesses and for personal finances thus not accepted under GAAP.
Applications of Accrual Basis
- Larger companies are required to use the accrual method of accounting if their average gross receipt of revenues is more than $25 million over the previous three years.
- Any company that files audited financial statements should adopt accrual basis method as a requirement under GAAP.
- Accrual accounting is always required by companies that carry inventory or make sales on credit, regardless of the company size or revenue.
- Tracking assets and liabilities: In addition to cash on hand, businesses also count checks, short-term investments and inventory as assets. Likewise, any unpaid expense is a liability, acknowledged before bills get paid rather than after payments are sent Accrual accounting makes it easier to distinguish assets and liabilities by keeping up-to-date records of what items fall into either category and for how long.
- Accrual-basis accounting meets Generally Accepted Accounting Principles (GAAP)) standards as set by Financial Accounting Standards Board (FASB) thus Public companies have to adopt the accrual method to be compliant.
Why shift to accrual accounting?
- Under accrual accounting, firms have immediate feedback on their expected cash inflows and outflows, making it easier for businesses to manage their current resources, project future financial reports and easy to prepare cash flow statements and recognize financial trends.
- The accrual method provides companies with an accurate picture of the company’s financial health. It includes receivables and liabilities, match revenues with expenses, helping the organization to monitor the true profitability trend. In addition, it provides a more accurate picture of a company’s financial position.
- The detailed company’s finances insight under accrual method provides a better long-term financial view. The owner of the business can track how much money was earned and spent at a given time, despite payment dates. The insight will help in creating a better plan based on highs and lows throughout the year. Further, it gives a very clear picture of financial responsibilities and financial resources. Accrual accounting proves to be an excellent methodology for a company to manage debt, income, and financial activity.
How to choose the right accounting method for your business
The differences between cash and accrual–based accounting often depend on the size of your business and its average annual revenues. Generally, small businesses prefer cash accounting as it’s easier to understand and maintain. Although accrual accounting doesn’t provide easier way of tracking cash flows, it helps organizations to get a clear idea of expenses and income for a given accounting period. The International Reporting Standard (IRS) gives guidelines on how to choose the best accounting method for the business. According to IRS the company cannot adopt cash method if the business:
- Offers credit to customers or maintains product inventory since it does not take into account receivables and payables. A company whose gross receipts cross the $25 million threshold is restricted from adopting cash basis as method of accounting thus cash accounting method not suitable for all businesses.
- Accrual accounting is the better choice for the business that handles extensive inventories, for companies whose gross revenue is $ 25 million and above however even small business with gross revenue less than $25 million is applicable. Accrual is being convenient and universal to all kinds of business.
Conclusion
- Accounting methods are tools for businesses to use in order to record their finances and keep track of their finances. The two most popular accounting methods that businesses use are accrual accounting and cash accounting. When comparing the two methods, the cash accounting method is an easier way to record financial records and track cashflow. However, its usage is restricted to businesses that do not offer credit to customers or maintain product inventory since it does not recognize receivables and payable. Without a record of accounts receivable or accounts payable, may inadvertently cause the omission of certain assets and liabilities. In addition, it may be harder to correctly grasp a business’s current financial health, potentially causing major discrepancies. Secondly, it is only applicable to sole proprietors and businesses whose average turnover is below $ 25 million for the last year, whenever the company expands and its earning cross $ 25 million the company is forced to Switch from cash to accrual this can be cumbersome. Starting with accrual accounting from the outset helps organizations to avoid such challenges down the line. Although accrual accounting method, may be more complicated than the cash method, it allows businesses to see expenses as they are happening. It is a transparent method to see actual revenue real-time view and accurate assessment of finances. It is a tool for good management of debt and income and offers a clear picture of a company’s financial health as it smooths out earnings over time.
- Accrual accounting generally makes the relationship between revenue and expenses clearer, providing better insight into profitability. It also offers a more accurate picture of a company’s assets and liabilities on its balance sheet. It is the more popular one of the two, being convenient and universal to all kinds of business and conforms to the Generally Accepted Accounting Principles (GAAP).
The author is a member of ICPAK Research & Development committee South Rift Branch- Youth Representative
Email; nyachwayazippy@yahoo .com
