Accrual basis accounting is an accounting method that recognizes revenues and expenses when they are earned or incurred, regardless of when the actual cash transactions occur. In this approach, financial transactions are recorded as they occur, and revenues are recognized when they are earned, not necessarily when the payment is received. Similarly, expenses are recognized when they are incurred, even if the payment is made at a later date.
Key principles of accrual basis accounting:
- Revenue Recognition: Revenue is recorded when it is earned and becomes reasonably certain, regardless of whether the cash has been received. For example, a company that delivers goods or provides services to a customer would recognize the revenue at the time of delivery or completion of the service, not when the customer pays.
- Expense Recognition: Expenses are recorded in the period they are incurred, matching them with the revenues they helped generate. For example, if a company purchases inventory to sell to customers, the cost of goods sold (COGS) is recognized when the inventory is sold, not when the payment for the inventory is made.
- Accruals and Deferrals: To align revenues and expenses with the periods they relate to, accruals and deferrals are used. Accruals involve recognizing revenues or expenses before cash is exchanged, while deferrals involve recognizing revenues or expenses after cash is exchanged. Examples of accruals include accounts receivable and accounts payable, while prepaid expenses and unearned revenue are examples of deferrals.