Large companies that sell goods on credit may continue to receive revenue over a long period of time from goods that were sold earlier. The accrual method of accounting came into use as a response to the increased complexity of business transactions. The Need for the Accrual Principle The complexity of business transactions Therefore, a business that uses the cash accounting method may not always present the most accurate view possible of its real financial position. However, if the business sells goods on credit through internal financing, then it would be unable to account for the future payments, since cash accounting, unlike the accrual accounting method, does not have a means of recording future payments. The advantage of this method over the accrual method of accounting is that a business can account for all the physical money it has on hand. This method is restricted to small businesses that do not have significant volumes of transactions. The cash accounting method records revenue and expense transactions when the payments are physically received or paid out. Similarly, when an expense bill is received, it is recorded in the expense account as such, even before payment for the expense is made. When the goods are delivered to the customer, the payment is transferred from the liability account to the revenue account. In such an instance, the payment is initially recorded as a liability for the seller (because, having received the payment, the business is then liable for delivering the goods). On the other hand, some customers may pay for the goods before the goods are delivered to the purchaser. The accrual method requires businesses to factor in “allowance for doubtful accounts” since goods are delivered to customers prior to payments being received, and some customers may fail to pay. The accrual method of accounting is based on matching revenues against expenses in the period in which the transaction takes place, instead of when the payment is processed, which is the procedure with cash accounting. The main difference between accrual accounting and cash accounting lies in the period in which revenues and expenses are recorded as having occurred. Businesses earning over $5 million in revenues are required to use the accrual principle for tax purposes. Large businesses consider the accrual principle the most valid accounting system for determining the financial position and cash flows of their business operations, with revenues and related expenses recorded within the same reporting period. These accounting frameworks provide guidelines to businesses around the world on how to account for revenues and expenses apart from just using cash receipts. The accrual concept is considered to be standard accounting practice for large companies and is supported by both the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP). The idea behind the accrual principle is that financial events are properly recognized by matching revenues against expenses when transactions – such as a sale – occur, rather than when the actual payment for the transaction may be received.įollowing the accrual principle in accounting provides a more accurate picture of the actual financial status of a company, but it is a more onerous method for small businesses to adopt. The accrual principle is an accounting concept that requires transactions to be recorded in the time period in which they occur, regardless of when the actual cash flows for the transaction are received. Updated DecemWhat is the Accrual Principle?
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