Definition
The Accrual Method of accounting is a method that requires income to be recorded when it is earned and expenses to be recorded when they are incurred, irrespective of when the cash transactions actually occur. This approach provides a more accurate picture of a company’s financial health by including information on future cash inflows and outflows.
Examples
-
Insurance Expense:
- Scenario: A home buyer purchases a 3-year hazard insurance policy at closing.
- Accrual Method: Only the current year’s insurance expense is recorded.
- Cash Method: The total payment for the 3-year policy is recorded at the time of purchase.
-
Loan Interest Expense:
- Scenario: There is a loan on which interest is 3 months delinquent.
- Accrual Method: The unpaid interest expense for those 3 months is recorded in the current year’s financial statement.
- Cash Method: The interest expense is recorded when it is actually paid.
Frequently Asked Questions
Q1: What is the primary difference between the accrual method and the cash method?
A1: The accrual method records income and expenses when they are earned or incurred, whereas the cash method records these only when cash is exchanged.
Q2: Why do companies use the accrual method of accounting?
A2: The accrual method provides a more accurate and comprehensive view of a company’s financial position by recognizing revenue and expenses in the period they occur, rather than when cash is received or paid.
Q3: Can small businesses use the accrual method?
A3: Yes, small businesses can use the accrual method, although they are more likely to use the cash method due to its simplicity. However, certain regulations and business models may require the use of the accrual method.
Q4: Is the accrual method required for any specific types of businesses?
A4: Public companies and larger businesses are often required to use the accrual method, particularly those adhering to Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
Q5: What is the main benefit of using the accrual method?
A5: The main benefit is the accuracy and completeness of financial statements, allowing for better decision-making and financial planning.
- Cash Method: An accounting method recording revenues and expenses only when cash transactions occur.
- Revenue Recognition: The accounting principle that dictates when revenue is accounted for and recognized in financial statements.
- Expense Recognition: The accounting principle stipulating when expenses are deducted.
- Matching Principle: An accounting principle that expenses be reported in the same period as the revenues they help generate.
Online Resources
References
- Financial Accounting Standards Board (FASB), Generally Accepted Accounting Principles (GAAP)
- International Accounting Standards Board (IASB), International Financial Reporting Standards (IFRS)
Suggested Books for Further Studies
- “Financial Accounting” by Jerry J. Weygandt, Donald E. Kieso, and Paul D. Kimmel
- “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
Real Estate Basics: Accrual Method Fundamentals Quiz
### When is income recorded under the accrual method of accounting?
- [x] When it is earned
- [ ] When cash is received
- [ ] At the end of the fiscal year
- [ ] When expenses are paid
> **Explanation:** Under the accrual method, income is recorded when it is earned, regardless of when the cash is received.
### In the accrual method, when are expenses recorded?
- [ ] When cash is paid
- [x] When they are incurred
- [ ] At the end of the fiscal year
- [ ] When income is recorded
> **Explanation:** Expenses are recorded when they are incurred in the accrual method, not necessarily when they are paid.
### Which method provides a more accurate picture of a company's financial health?
- [x] Accrual method
- [ ] Cash method
- [ ] Hybrid method
- [ ] Profit method
> **Explanation:** The accrual method provides a more accurate picture of a company's financial health by recognizing revenues and expenses when they occur.
### Under which method are future cash inflows and outflows accounted for?
- [x] Accrual method
- [ ] Cash method
- [ ] Future method
- [ ] Past method
> **Explanation:** The accrual method accounts for future cash inflows and outflows by recognizing upcoming obligations and earned revenues.
### What is a key disadvantage of the accrual method for small businesses?
- [ ] Complexity in meeting GAAP
- [ ] Requirement to pay taxes on uncollected revenue
- [x] It is generally more complex and time-consuming
- [ ] Limited accuracy of records
> **Explanation:** The accrual method is generally more complex and time-consuming compared to the cash method, which can be a disadvantage for small businesses.
### What principle states that expenses should be recorded in the same period as the revenues they help generate?
- [ ] Revenue Recognition Principle
- [ ] GAAP Principle
- [x] Matching Principle
- [ ] Income Principle
> **Explanation:** The Matching Principle states that expenses should be recorded in the same period as the revenues they help generate, aligning with the accrual method.
### Which companies are typically required to use the accrual accounting method?
- [ ] Start-ups
- [ ] Small local businesses
- [x] Public companies and larger businesses
- [ ] Non-profit organizations
> **Explanation:** Public companies and larger businesses often are required to use the accrual accounting method as per GAAP or IFRS standards.
### Is it permissible for businesses to switch between the cash and accrual methods?
- [x] Yes, with IRS approval and consistent application
- [ ] No, once a method is chosen it cannot be changed
- [ ] Only on a year-by-year basis
- [ ] Yes, without any restrictions
> **Explanation:** Businesses can switch between cash and accrual methods, but they must get IRS approval and apply changes consistently.
### How does the accrual method affect short-term financial resources monitoring compared to cash method?
- [x] It may complicate short-term resource monitoring
- [ ] It significantly eases monitoring
- [ ] It has no impact
- [ ] It immediately improves short-term ratings
> **Explanation:** The accrual method does provide a comprehensive financial picture, but it may complicate short-term financial resource monitoring compared to the cash method.
### What is a major consideration when deciding between the accrual and cash method?
- [ ] Color of financial records
- [ ] Size of the company’s revenues
- [x] Accuracy of financial position representation
- [ ] Level of management experience
> **Explanation:** One major consideration is the accuracy of the financial position representation, which is typically more precise under the accrual method.
