When transactions are reported in the books of accounts when they occur even if the payment for that specific good or service has not made or obtained, it is known as the accrual accounting method.
In simple words — the company records revenue when the transaction is completed, even if the customer has not made any payment for it yet.
This method plays a crucial role in evaluating the organization’s success as it provides a real-time financial picture of an organization.
Accrual method follows the matching principle, which states that revenues and expenditures must realize in the same accounting period they incur.
In industries where there are many credit transactions or the products and services that sell on credit, accrual accounting is usually beneficial, which means no cash exchange.
An example of the accrual concept:
If an ABC company makes a sale in April but collects money in May, accrual accounting means that ABC company should recognize the sales in April in their accounts when the invoice was generated and not when the payment is completed.
Advantages of the accrual accounting method:
- It allows organizations over a specific time to keep an accurate summary of their financial activity.
- It is an efficient way for organizations to forecast what they may see in their potential expenditure reports.
- It is easier to match the paperwork with the accrual method and give the organization a clear understanding of how much they invest and how much profit they make.
- Accrual accounting helps to understand accounting confusion regarding income and liabilities better. As a consequence, while keeping future liabilities in check, companies can often better anticipate revenues.
According to UK rules, this method must be used by incorporated businesses with a turnover of over £ 150,000. Suppose you start the year expecting your turnover to be below that and you use the method of cash accounting. In that case, you can continue to use it as long as your turnover does not increase above £ 30,000, but you should use the accrual accounting method in the following year.
The accrual method is more preferred:
- At the end of an accounting period, the companies require more detailed reporting of their assets, liabilities, and stockholders’ equity.
- A more detailed reporting of a company’s revenues, expenditures, and net income require a precise time interval based on a monthly, quarterly or annual basis.