Companies account for financial transactions using either the cash method or the accrual method. The cash method records transactions only when money is paid out or received. The accrual method records transactions as they occur. With the accrual method, cash does not need to be paid or received in order for a transaction to be recorded. Identifying the accrual method is done by looking for a few key indicators. With accrual accounting, several accounts are used that are not used with the cash method.
Understand the concept of accrual accounting. Whenever a transaction is made, it is recorded. This includes transactions such as accounts payable and accounts receivable. With accounts payable, something is purchased on account. A good or service is received but is paid for later. With the cash method, there are no accounts payable or accounts receivable, nor are there any inventory or depreciation accounts. All inventory purchases are placed into a purchase account and assets are either wrote off when purchased or not wrote off at all.
Identify deferred revenue accounts. A balance sheet is made up of assets, liabilities and equity accounts. Accrual accounting uses deferred revenue accounts. Deferred revenue is when a company receives money for a good or service prior to providing the good or service to the customer. This causes the company to record this transaction as a receipt of cash and a liability to unearned revenue. Unearned revenue is a liability account that is placed on a balance sheet. Any unearned accounts represent liabilities and are listed on the company’s balance sheet.
Identify accrued expense transactions. Accrued expenses occur when a company receives a service or expense and has not paid for it. Accrued expenses are posted to expense accounts and posted to a liability account. The liability accounts are all listed on the company’s balance sheet. Some accounts used to identify accrual accounting are salary expense, interest expense, depreciation expense and amortization.
Look for deferred expenses. Deferred expenses are expenses that are prepaid. They are placed into asset accounts originally, and as they are used, the amounts are then transferred to expense accounts. Deferred expenses are often known as prepaid expenses. Prepaid insurance and prepaid rent are examples of deferred expenses.
Look for accumulated depreciation. Companies using accrual accounting depreciate fixed assets. When assets are depreciated, a portion of the assets are expensed out each year. A contra asset account, accumulated depreciation, is used to track the total amount of depreciation expensed out for each particular asset. Accumulated depreciation is listed on the balance sheet underneath the asset it correlates to. It is a positive indicator that the company is using the accrual accounting method.