Accrual Accounting
An accounting method that measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur. The general idea is that economic events are recognized by matching revenues to expenses (the matching principal) at the time in which the transaction occurs rather than when payment is made (or received). This method allows the current cash inflows/outflows to be combined with future expected cash inflows/outflows to give a more accurate picture of a company's current financial condition.
Accrual accounting is considered to be the standard accounting practice for most companies, with the exception of very small operations. This method provides a more accurate picture of the company's current condition, but its relative complexity makes it more expensive to implement. This is the opposite of cash accounting, which recognizes transactions only when there is an exchange of cash.
Investopedia Commentary
The need for this method arose out of the increasing complexity of business transactions and a desire for more accurate financial information. Selling on credit and projects that provide revenue streams over a long period of time affect the company's financial condition at the point of the transaction. Therefore, it makes sense that such events should also be reflected on the financial statements during the same reporting period that these transactions occur.
For example, when a company sells a TV to a customer who uses a credit card, cash and accrual methods will view the event differently. The revenue generated by the sale of the TV will only be recognized by the cash method when the money is received by the company. If the TV is purchased on credit, this revenue might not be recognized until next month or next year.
Accrual accounting, however, says that the cash method isn't accurate because it is likely, if not certain, that the company will receive the cash at some point in the future because the sale has been made. Therefore, the accrual accounting method instead recognizes the TV sale at the point at which the customer takes ownership of the TV. Even though cash isn't yet in the bank, the sale is booked to an account known in accounting lingo as "accounts receivable" and the seller's revenue has increased.
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See also: Accounting, Accounts Receivable - AR, Accrued Expense, Accrued Interest, Balance Sheet, Cash Basis, Cost Of Goods Sold - COGS, Credit, Income Statement
accrual accounting
Case Study Recording revenues that are used to calculate earnings before actually receiving those revenues can potentially misrepresent a firm's financial results and lead to financial difficulties down the road. For example, a company that ships substantial amounts of goods on credit may produce outstanding earnings in the current accounting period, but if customers who receive the goods fail to pay for the merchandise, future earnings are likely to suffer. Firms build an estimate for doubtful payments into the revenues and earnings they report, but the estimates may be understated and make earnings look better than they actually are. More than a few companies have been known to ship unusually large amounts of merchandise near the end of a fiscal year in order to make the year's sales and earnings appear favorable even though the extra sales produce an unrealistic picture of the firm's operations. In one instance, a large toy company was offering special incentives to customers that loaded up with the firm's merchandise just prior to the end of the year. This, of course, is perfectly legal. However, the company offering the incentives was accused of overstating its earnings by not properly accounting for the expense of the incentives being offered. A firm that aggressively pursues end-of-year sales may end up selling to some financially weak customers who fail to pay for the merchandise. Unfortunately, it is difficult for stockholders to know the extent to which a firm's actions serve to puff up the financial statements rather than produce real results. |