ACCRUAL ACCOUNTING BASIC INFORMATION AND TUTORIALS

What is Accrual Accounting? When to do accrual accounting?

The accounting rules outlined in GAAP, require that most companies keep their accounting records on the accrual basis. The alternative is the cash basis, meaning a transaction is recorded only when cash changes hands.

Cash basis accounting is not considered indicative of economic realities, thus the requirement for accrual accounting except for certain kinds of companies, such as very small businesses and some not-for-profit organizations.

When the Sales Department obtains an order from one of your customers and the product is shipped to the customer, a sale has been consummated and it is recorded. This transaction will appear on the income statement even though not a single dollar may have passed from the customer to your company, because the customer has an open account with the company.

The transaction is recorded by increasing Sales and by increasing Accounts Receivable, the amount due from your customer. Later on, perhaps the following month, your customer pays his or her bill and your company receives the cash.

That transaction will not appear on the income statement. It was already recorded as income when the sale was made and, under accrual accounting rules, only the sale itself is considered an income producing event, not the act of collecting the money.

This example demonstrates the essence of accrual basis accounting. Transactions are recorded when an economic event is deemed to have occurred.

A sale is an economic event because a binding agreement has been reached: your customer agreed to accept the merchandise and pay for it in due course and your company shipped the merchandise on your customer’s promise to pay. That is an economic event, an offer made and accepted.

The customer’s payment is another economic event. It is related to the first, but it is nevertheless a new event. The customer might have chosen to delay his or her payment or return the merchandise, but chose instead to pay for it.

The second economic event doesn’t affect Sales. However, it affects the balance in the customer’s account and it increases your company’s cash receipts.

So when this transaction is recorded, Accounts Receivable and Cash are the accounts that are affected. This transaction, although not shown on the income statement, will be included in the statement of cash flow, which documents transactions other than those that affect income and expense.