Accounting essentially comes in two flavors: cash and accrual basis. Under the cash basis, transactions are recognized when money changes hands. When you pay bills, you recognize expenses and when you receive funds, you recognize revenue. The financial statements prepared on a cash basis do not show accounts receivable or payable or accruals.
Under the accrual basis, income and expenses are recognized when they occur, regardless of when they are paid. This method tries to match the time of expenses with the income associated with them. For example, suppose commissions are paid next year for sales that occurred this year. In this case, the expense is recognized this year, not in the future, when the commission is actually paid. Commission spending would increase this year. The term “accrual” is used to indicate that an item has now been recognized as income or expense.
When you view a sales and expense amount on an income statement using the accrual basis of accounting, all of the numbers may reflect accounts receivable and payable, not actually cash received. For example, you see a rent expense of $10,000 on your financial reports. It does not mean that the company actually paid $10,000; it may be that $8,000 was paid and $2,000 was recognized now but to be paid in the next period. In other words, the $2,000 was increased.
Special Accounts–Expenses
You know that a large bill was paid off recently, after the end of the year. The question usually arises: Is this invoice included in the year-end budget/report? In other words, did this expense/bill increase at the end of the year? If the amount was accrued, it should be part of Expenses and Accounts Payable on your books. In many businesses, an increased account payable is established separately from the regular account payable to keep the accounting organized.
Expenses can be paid in advance, such as an insurance policy that may be valid for a couple of years. Under accrual accounting, prepaid expenses are recognized over time, not all at once. For example, suppose you have a $2,000 premium for a two-year policy. $1,000 is recognized each year as an expense in the income statement, not the full $2,000.
Special Accounts – Income
A business that uses accrual accounting would handle revenue similarly to expenses. For example, suppose you provided the service this year, but you will be paid next year. You increased revenue this year, that is, you recognize revenue now in the income statement because the work was actually performed this year. The journal entry is to debit the increased accounts receivable and credit the income statement account.
Companies sometimes receive deposit advances for work to be delivered in the future. In this case, the income is not recognized in the profit and loss account for this year, but when the work is carried out. When funds are received, the input is to debit cash and credit a “deposit” or “deferred income” account, reporting on the balance sheet. This situation is common with schools that require deposits prior to the school year; revenue is recognized in the income statement only when school begins.
Other considerations
Another feature of accrual accounting is the concept of capitalized assets and depreciation. When you buy a major piece of equipment, in cash you would spend it all in the period it was paid for. Under the accrual basis, you capitalize equipment and then depreciate it over time through depreciation. If you see “Depreciation expense” on an income statement, the company is using the accrual basis of accounting.
Some companies use a “modified modified basis” of accounting with both cash and accrual elements. However, banks and investors generally require accrual accounting. The cash basis is simpler, but the accrual basis is a much more reliable basis because it presents a healthier financial picture with the presence of accounts receivable, payable, accruals, and other information that can give stakeholders a much better picture. clearer of a business.