Accrual Accounting

Accrual accounting is necessary for many businesses due to the accounting matching rule, which states:

  1. Revenues must be assigned in the same period in which the related services were rendered or cost of goods sold was expensed.

  2. Expenses must be assigned to the same period that the expenses were used to produce revenues.

    Cash basis of accounting:

    • Some businesses and individuals can use the cash basis of accounting, where:

      • Revenues are recognized when received
      • Expenses are recognized when paid

    • The cash basis of accounting does not work for most businesses because:

      • Taxing authorities do not allow it on tax forms.
      • The financial statements for any given period are not as accurate, since events are not recorded as they occur.

    How accrual entries are made:

    • In order to put the revenue and expenses in the proper periods, accrual entries need to be made.

    • Accrual accounts such as accounts receivable and accounts payable are used.

    Here are examples of entries that would be used to record revenue that has been earned, but not received at the end of the period:

    Accounts Receivable        $10,000
            Revenue Earned                    $10,000
                (to recognize revenue earned but not received)

    At the beginning of next period the payment is received from the customer:

    Cash                                $10,000
            Accounts Receivable                $10,000
                (to recognize payment received from customer)

    Here is an expense accrual entry:

    Supplies Expense                $1,000
            Accounts Payable                    $1,000
                (record expense not paid as of end of period)

    In the next period the expense is paid:

    Accounts Payable                $1,000
            Cash                                        $1,000
                (record payment for supplies)

    By using accruals, the financial information reported is much more accurate than using cash basis accounting. Care needs to be taken by the Accountant to recognize all the economic events that should be recorded in the current period.

    Some other events that need to be accrued:

    • Depreciation expense

    • Prepaid rents

    • Unearned revenues