Definition: A method of accounting for a business’ activities that recognizes revenue when it is earned (and not when cash is received) and expenses when they are incurred (and not when they are actually paid).
Example: Schmitt Corp. has 10 employees who each have an annual salary of $52,000, which equates to $1,000 per week. To cut down on paperwork, the company pays the employees $2,000 every other Friday. On the Friday between paydays, the company is asked to produce financial statements showing the state of its business. Before it can produce accurate statements, it must make a bookkeeping entry to record the fact that all the employees are owed one week of salary. It has accrued to them.
Investeach explains: Continuing with the above, if the $10,000 in salaries owed was not recorded, the profits of the company would be overstated by that amount. This demonstrates that businesses can have expenses before it pays for them. On the other hand, businesses can also achieve sales after providing goods and services to their customers. For example, an electronics store has a right to record a sale after it delivers and installs a TV at a customer’s home even if the customer does not pay at the time of delivery.
Note that accrual accounting is time consuming and costly to do properly. For this reason, the Internal Revenue Service (the government’s tax collection department) allows small companies the option of only recording business activities when cash moves and out of the business. See Cash basis accounting.
Riddle me this:
1. A tire company takes a full page advertisement in the December issue of Motor Trend magazine. It receives the bill from Motor Trend in December but pays it the following January. Identify in which month an advertising expense should be recorded, and why.
2. Explain why accrual accounting results in more accurate financial reporting than cash basis accounting.
3. Explain why the Internal Revenue Service nevertheless allows small companies to use cash basis accounting.
Opposite of: Cash basis accounting.