accrual basis accounting

accrual basis accounting

Accrual Basis Accounting

1. Introduction to Accrual Basis Accounting

The basic concept of accrual basis accounting is that accounting transactions are recognized when they occur regardless of when cash changes hands. This means that revenue is recorded in the period when the details of the customer or client order are fully provisioned and the company becomes obligated to provide specific obligations to the customer or client. It does not depend on when cash is received. Similarly, expenses are recorded when the company knows it has incurred an obligation, not when the obligation is paid off. Accruals are the adjustments necessary to update the accounting records for transactions that have occurred but are not yet recorded, again regardless of when cash actually changes hands. Accrual basis accounting conforms to the matching principle that expenses should be recognized in the accounting period in which they were incurred, not when they are paid.

Accountants generally use an accounting practice called accrual basis accounting, which involves recording transactions when they occur, not necessarily when cash changes hands. The main advantage of accrual basis accounting is that it can provide a much more accurate picture of a company’s financial condition than cash accounting, which records only cash receipts and payments. However, while accrual accounting does a better job of matching revenue and expenses than cash accounting, it also poses some significant disadvantages. Accrual accounting requires a far greater amount of judgment than cash accounting, as well as a greater amount of accounting transactions than does cash accounting.

2. Benefits of Accrual Basis Accounting

A vital feature which contributes to the quality of accounting data derived and reported is a requirement that significant elements of the government’s transactions and events be recognized in financial statements in the same period in which they occur. Recipients of governmental financial statements are thus more easily able to properly evaluate if the following accountability, responsiveness, and effective stewardship concerns have been satisfactorily addressed. For this and other reasons, the U.S. Securities and Exchange Commission (SEC) and the world’s leading bond rating agencies are strong advocates of government-wide GAAP. Notably, the Financial Accounting Standards Board (FASB) writes, “The accrual basis of accounting provides more relevant information than the cash basis, which includes only inflows and outflows of resources, because it incorporates all the resources and obligations related to government activities. It provides a more comprehensive measure of a government’s transactions.”

The most significant benefit of adopting a basis of accounting for a government is to ensure that the governmental unit is reporting to its citizens in compliance with a conceptual framework that explains how information about its financial position and activities should be measured, presented, and disclosed. Besides the key reason of meeting the requirements of the conceptual framework, there are a number of additional features that result from the utilization of generally accepted accounting principles (GAAP) that are based long-term on the accrual basis that are highly beneficial. For example, these features enhance the “service efforts and accomplishments” (SEA) varieties of performance information; moreover, they have allowed for increased consistency and comparability in financial performance reporting.

3. Key Principles of Accrual Basis Accounting

– Money Measurement Principle: According to which all transaction values are expressed in monetary units and recognized in financial statements only if they can be expressed in monetary units.

– Entity Assumption: According to which all assets and liabilities belong to the enterprise, and they are separated from assets and liabilities of the enterprise’s owner, as well as from assets and liabilities of all other enterprises. – Going Concern Assumption: According to which it is believed that an enterprise is going to be business-wise operational for an indeterminately long time period. Therefore, all assets and liabilities are measured in accordance with this principle.

According to real-life accounting theory and practice of accrual basis accounting, there are several principles that have to be taken into account when you record a business transaction. These principles are useful not only from a theoretical, but also from a practical point of view, because it is safe to say that these principles enable accounting from becoming an impossible mission (we can say that “almost everything can be accounted for…”). Therefore, we have prepared a list of the most important principles you would have to be aware of (almost all of these are employed in Croatia), and those are:

4. Challenges and Limitations of Accrual Basis Accounting

The realization of an asset or a liability might not be certain, and although the item is recognized, an appropriate note to the financial statements should disclose any uncertainties. The value of goodwill that arises from the acquisition of a company or an asset has to be estimated and amortized. When an entity does not develop its own measuring system, appropriate sources for the estimated values have to be found and used. Large conglomerates may, by themselves, have an expertise to develop appropriate processes for the estimation of the financial items. Yet the risk is substantial that the managers of the conglomerate will be motivated to manipulate estimates. This usually presents a higher risk for entities that have no appropriate expertise and that outsource the production of the financial statements. Accrual basis accounting, therefore, may not be appropriate for entities that have to rely on inappropriate sources for the estimates and face a significant risk of estimates manipulation by the sources.

Accrual basis accounting provides a more accurate picture of the financial situation of an entity than cash basis accounting. Nonetheless, accrual basis accounting has many challenges and limitations. The difficulties in measuring and reporting many financial items are increased by the use of accrual basis accounting. Revenue is to be recognized by matching the costs that led to the generation of the revenues. There often is a considerable gap between the time of generating the costs and the collection of cash from the sale of goods and services. Estimates of cost and revenues have to be used for many financial items and the recognition in the financial reports is not perfect but only a close approximation. The classification of an expense as a capital asset or as an expense of the period often presents a significant judgment. Except for the cash and immediately settled financial items, the market value for most assets and liabilities has to be estimated.

5. Conclusion

Want to be a systems programmer in a large commercial enterprise? Intellectually, you can compete for one of those jobs with a thorough grounding in the concepts of software engineering, or you can compete with an understanding of accounting that allows you to understand the meaning of management information reports. Want to be a producer or director in the entertainment industry? You can compete in that industry with a significant repertoire of film-making techniques and interpretive analyses of film scripts – or you can compete with an understanding of the economics of the entertainment business. Leave out the underlying structure of business, and you will simply be unemployed in the 21st century.

To survive, managers and advisors in the 21st century need to be able to read and understand financial reports. Without an understanding of economic and accounting concepts, students either simply do not understand business operations, or they must work out an explanation for what is happening that may be entirely unrelated to business reality. The reason for this lack of understanding of business operations is this: Students are not being properly introduced to the language of business operations – namely, accounting and economics – on which virtually all human endeavor is based.

Despite a few problems, learning the language of accounting is not particularly difficult and will pay significant benefits in the long run. Whatever the level of “expertise” achieved in accounting, learning one’s way around its vocabulary is essential to understanding basic business operations. It is the basic language of business operations in every country in the free world. If you cannot understand accounting terminology, you will simply not understand business. I encourage you to dig in and embrace the language of business.

The objective of this brief manual is designed to provide small and medium enterprise owners, their advisors, staff, and students with a fundamental understanding of the basic concepts and principles of accounting. It also aims to provide a general understanding of the language that is a major part of the operation of any successful business. Anyone who wants a better understanding of the concepts described should pick up a book on accounting principles or attend an accounting course, which will treat these concepts in a more comprehensive manner.