Accrual Method of Accounting

Maintaining books of accounts is a must for all companies. This helps the company and outside agencies such as shareholders, creditors and tax department to know of the financial strength and transactions of the firm in a given financial year. There are many methods of accounting, such as the cash method, the cost method and accrual method of accounting.

This method of accounting is also known as accrual accounting or accrual basis accounting. There are two very important rules about income and expenses in this method of accounting.

In the accrual method, the income is reported in the period it is earned. Even if the income is received or not, the accountant has to include the income in the books of accounts.

In this method, the expenses made by the firm are deducted in the same fiscal period irrespective of whether these are actually paid or not.

The accrual method is perhaps the best method to gauge the present financial condition of a company due to the combination of current cash inflows and outflows with the expected cash inflows and outflows in the future.

The accrual method assumes that when a company makes a sale, the revenue will be received in the coming future, and it includes the sale in the accounts of the company. On the other hand, in the cash method of accounting, the sale will not be reported until the company gets all its dues.

XYZ is a company in the consumer goods business. It sells a few air-conditioners to a company in a particular month. Now, if the company makes prompt or instant cash payment for the air-conditioners, then the cash method of accounting will consider it as a 'sale made' and enter the details into its books.

On the other hand, if the items have been purchased on credit, the revenue will not be recognized till the company receives its payment.

On the contrary, in the accrual accounting method, the sale is registered at the point the company takes possession of the air conditioners. The company recognizes the sale even though cash has not been received and maintains record of such transactions in the 'accounts receivable' account.

There is always a debate on who should use this method of accounting. Although this method is the most suitable for almost all kinds of businesses, those businesses which have inventories on a large-scale should certainly opt for this method.

However, for small businesses, the accrual method can lead to payment of more taxes due to higher reporting of net income for a year. Consider this example, A salesman makes sales of $3000 to a customer in December.

While doing so, his personal expenses are around $1000 and hence his profit would be $2000 for the items sold. Let us assume that he will get his payment from the party only next year.

So, if he uses cash accounting method, he will not have to report gains from this transaction and hence the tax would be less. On the contrary, if he uses the accrual method, he will have to report this revenue even though the money is not yet in his bank. So, his tax liability increases.

There is no doubt that the accrual method of accounting is extremely useful in businesses which are expanding rapidly and have many transactions to record.

By studying the nature of your business, you should take a decision about which type of accounting would suit you better. So, put on your thinking caps and do the job by following accounting conventions and principles.