Accrual Basis Accounting
The accrual basis accounting method calls for the recording of economic business events as services are provided or consumed; not when cash is received or paid. Therefore, the accrual method of accounting requires the reporting of revenues as they are earned and expenses as they are incurred.
ExplanationThe accrual basis of accounting is one of two commonly accepted accounting methods, the other being the cash method of accounting. While the accrual method requires the reporting of revenues as they are earned and expenses as they are incurred, the cash method calls for the reporting of cash transactions as they occur.
The accrual method of accounting follows the matching principle, which calls for the reporting of revenues and expenses in the same time periods in which they occur. This method is deemed a more accurate way to account for costs and revenues. It's also the most commonly used accounting method, especially among companies with over $5,000,000 in revenues.
The processes and systems required to support accrual accounting can be quite complex, and companies have some flexibility with rules governing the need for an accrual. Oftentimes, dollar value thresholds are established based on the potential impact on the company's financial statements. For example, a company with $10 billion in revenues may not require employees to accrue expenses that are less than $10,000. Companies may also be required to perform complex calculations involving unbilled revenues.
There are two balance sheet accounts which are critical to the accrual method of accounting:
- Accounts Receivable: non-written promises to pay for goods or services received but not yet paid for by a customer.
- Accounts Payable: balances owed to trade partners for materials, supplies, goods and services that were purchased on credit.
Company A hires an implementation vendor to configure their new customer system over the next 24 months. The total vendor costs will be $48 million. Payments are made to the vendor based on milestones achieved in the project plan. The table below demonstrates how the accrual method aligns costs with the proper financial accounting period.