Accountants aim to provide reliable information to decision makers. Unlike cash basis accounting, which recognizes revenue when cash is received and expenses when paid, accrual basis accounting recognizes revenues as they are earned and expenses as they are incurred. For this reason, reports prepared using the accrual basis of accounting are a better indicator of a company’s financial position.
The matching principle requires that revenues be recognized is the same period as the expenses used to generate them. This can result in timing differences between when a transaction is recorded and when it economically impacts the company. Accounting systems manage many of these timing differences by design. For instance, accounts receivable is used to track uncollected revenues. In general, an accrual basis system will recognize revenue at the completion of the earning cycle – typically the invoice date. Accounts receivable permits a company to recognize revenues on the invoice date rather than on the payment date.
Accruals and Deferrals
Accounting systems do a decent job of tracking cash, accounts receivable and accounts payable, but in the absence of adjustments, there would be numerous violations of the matching principle in most companies. For this reason, accountants make accrual and deferral entries at the end of the accounting period to address timing differences standard bookkeeping procedures do not capture. Accruals accelerate the recognition of an item, where deferrals postpone recognition.
Revenue accruals are designed to accelerate the recognition of revenue earned but not yet recorded in accounts receivable. For instance, a firm accepts a contract that will last three months, but they are to be paid at the completion of the project. Assuming the work is spread evenly over the three months, 33 percent of the total revenue should be recognized each month. An accrual entry would be made to increase revenue on the income statement and increase accrued revenue on the balance sheet.
Expense accruals accelerate the recognition of an expense item not yet recorded in accounts payable. For instance, a bank may bill on the first of every month for the previous months loan interest. At the end of the period accountants will accrue the interest into the current period by increasing interest expense on the income statement and increasing accrued interest on the balance sheet.
Accruals are used to move items from one period to another, but often they need to be reversed to prevent the item from being recognized twice. For instance, the interest accrual mentioned previously would need to be reversed. An entry would be made on the first day of the next reporting period to decrease interest expense and decrease accrued interest by the amount accrued at the end of the previous period.
- “Intermediate Accounting”; Jan R. Williams et al.; 1995