Definition
Accrual Basis or Accrual Method is an accounting method in which transactions are recorded when they are earned, regardless of when the cash is actually received or paid. This method provides a more accurate picture of a company’s financial position by recognizing economic events regardless of when the associated cash transactions occur.
Examples
- Service Revenue: A consulting firm completes a project in December but does not receive payment until January. Under the accrual basis, the revenue is recorded in December when the service was performed.
- Prepaid Expenses: A company pays its insurance premium for the upcoming year in advance. Under the accrual basis, this payment is initially recorded as a prepaid expense and then allocated as an expense throughout the year as the insurance coverage is utilized.
- Accounts Payable: A business purchases supplies on credit in November but pays the bill in December. Under the accrual basis, the expense is recognized in November when the supplies are received, even though the payment is made later.
Frequently Asked Questions (FAQs)
What is the primary difference between the accrual basis and the cash basis accounting methods?
Under the accrual basis, revenues and expenses are recorded when they are earned or incurred, regardless of when the cash transactions occur. In contrast, under the cash basis, revenues and expenses are recorded only when cash is received or paid.
Who is required to use the accrual basis accounting method?
Taxpayers having inventories must use the accrual basis. Additionally, publicly traded companies and larger businesses often use this method as it provides a more accurate and complete financial picture.
Are there any exceptions to using the accrual basis for tax purposes?
Yes, exceptions include the recognition of bad debts and payments received in advance for services or merchandise.
Can small businesses use the cash basis instead of the accrual basis?
Yes, small businesses that meet certain revenue thresholds may be eligible to use the cash basis, which may be simpler and more straightforward.
How does the accrual basis affect financial statements?
The accrual basis provides a more comprehensive view of a company’s financial situation by recording revenues and expenses when they are earned or incurred. This results in financial statements that reflect the true economic activity of the company.
Cash Basis
Cash Basis is an accounting method in which transactions are recorded only when cash is received or paid. Unlike the accrual basis, the cash basis does not recognize accounts receivable or payable.
Accounts Receivable
Accounts Receivable represent money owed to a company by its customers for goods or services delivered but not yet paid for.
Accounts Payable
Accounts Payable represent money a company owes to its suppliers or vendors for goods and services received but not yet paid for.
Prepaid Expenses
Prepaid Expenses are payments made in advance for goods or services to be received in the future. They are initially recorded as assets and expensed over time as the benefits are realized.
Deferred Revenue
Deferred Revenue is money received by a company for goods or services that have not yet been delivered or performed. It is recorded as a liability until the revenue is earned.
Online References
- Investopedia - Accrual Basis
- IRS - Accounting Methods
- Accounting Coach - Accrual Basis Accounting
Suggested Books for Further Studies
- “Financial Accounting for Dummies” by Maire Loughran
- “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- “Principles of Accounting” by Belverd E. Needles, Marian Powers, and Susan V. Crosson
Fundamentals of Accrual Basis: Accounting Basics Quiz
### What is the primary feature of the accrual basis accounting method?
- [x] Transactions are recorded when they are earned or incurred.
- [ ] Transactions are recorded when cash is received or paid.
- [ ] Only expenses are recorded when incurred.
- [ ] Only revenues are recorded when earned.
> **Explanation:** The primary feature of the accrual basis is that transactions are recorded when they are earned or incurred, irrespective of cash received or paid.
### Which of the following businesses is required to use accrual basis accounting?
- [x] Businesses with inventories.
- [ ] Sole proprietorships with low revenue.
- [ ] Small independent contractors.
- [ ] Freelancers without large expenses.
> **Explanation:** Businesses with inventories are required to use the accrual basis to better match revenues with the cost of goods sold.
### How are prepaid expenses treated in accrual basis accounting?
- [x] They are recorded as assets initially.
- [ ] They are recorded as expenses immediately.
- [ ] They are always recorded as liabilities.
- [ ] They are not recorded at all.
> **Explanation:** Under the accrual basis, prepaid expenses are initially recorded as assets and then allocated as expenses over time as the benefit is utilized.
### In accrual basis accounting, when is service revenue recognized?
- [x] When the service is performed.
- [ ] When payment is received.
- [ ] When the invoice is sent.
- [ ] When the service is scheduled.
> **Explanation:** Service revenue is recognized when the service is performed, regardless of when the payment is received.
### Which of the following is a common challenge associated with accrual accounting?
- [x] It may require more complex bookkeeping.
- [ ] It does not match revenues with expenses.
- [ ] It is only useful for tax purposes.
- [ ] It only applies to cash transactions.
> **Explanation:** Accrual accounting often requires more complex bookkeeping to track revenues and expenses when they are earned or incurred rather than when cash changes hands.
### Why might a small business opt to use cash basis accounting instead?
- [x] To simplify bookkeeping.
- [ ] To better match revenues with expenses.
- [ ] To comply with tax regulations.
- [ ] To defer recognizing revenue.
> **Explanation:** Small businesses might use cash basis accounting to simplify bookkeeping and avoid the complexity of tracking accounts receivable and payable.
### What is one advantage of using accrual basis accounting?
- [x] It provides a more accurate financial picture.
- [ ] It is easier to manage than cash basis.
- [ ] It completely eliminates tax liability.
- [ ] It is simpler to use for freelancers.
> **Explanation:** The accrual basis provides a more accurate financial picture by recognizing revenues and expenses when they are earned or incurred.
### Which type of revenue can be recorded under the accrual basis?
- [x] Earned but not yet received.
- [ ] Received but not yet earned.
- [ ] Both earned and received.
- [ ] Only cash receipts.
> **Explanation:** Under the accrual basis, revenue can be recorded when it is earned, even if it has not yet been received.
### What is an example of a situation where accrual basis would be more appropriate than cash basis?
- [ ] A freelancer receiving immediate payment for every job.
- [x] A business with significant accounts receivable and payable.
- [ ] An individual managing personal finances.
- [ ] A small retail shop without inventory.
> **Explanation:** Accrual basis is more appropriate for businesses with significant accounts receivable and payable to match revenues and expenses properly.
### Can a business switch from cash basis to accrual basis accounting?
- [x] Yes, with proper adjustments and possible tax implications.
- [ ] Yes, but only at fiscal year-end.
- [ ] No, once a method is chosen, it cannot be changed.
- [ ] No, it is illegal to switch accounting methods.
> **Explanation:** A business can switch from cash to accrual basis accounting with proper adjustments and understanding of potential tax implications.
Thank you for embarking on this journey through our comprehensive accounting lexicon and tackling our challenging sample exam quiz questions. Keep striving for excellence in your financial knowledge!
