Explain accrual accounting

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Explain accrual accounting
Accrual is not a bad word ... just an accounting term. (The book-keeper in a warehouse of polygraphic production image by terex from Fotolia.com)

Accountants keep books using two methods: cash and accrual. Both methods have advantages and disadvantages, however, accrual is the "official" way of doing accounting in the UK. It recognises income and expenses without consideration about cash inflows or outflows.

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Definition

Accrual methodology is not based on cash transactions; instead it is based on the matching principle, indicating that expenses must be matched with revenue. Dates and timing in accounting is VERY important in the accrual method.

For example, commissions expense is reported in the period when sales occurred, not when the commissions were paid. Salaries or wages are recognised as an expense in the week when the employees worked and not when they are paid. If a firm wishes to give employees two per cent of its 2010 revenues as a bonus on January 15, 2011, the bonus is booked as an expense in 2010 with the unpaid amount as a liability on December 31, 2010. The journal entry in December would be a debit to bonus expense and a credit to bonus payable.

Revenues

Under the accrual method, income is recognised when services or products are provided, not when they are paid for. A revenue amount in the income statement may mean that cash was received, or that is part of accounts receivable. Recognition of revenue is independent from cash receipts.

Many times cash received is not recognised as revenue because services and products haven't been provided. For example, you receive £78 in magazine subscription for a year. You would book a debit to cash and a credit to deferred revenue, a liability account. If each month a magazine is sent out, then each month £6 would be recognised as revenue. The journal entry would be to debit deferred liability and a credit to revenue. After a year, the entire £78 would be recognised as revenue and there would be no deferred revenue.

Expenses

Expenses are recognised when they occur, not when they are paid. For example, a contractor provides services in January and sends you an invoice in February.You pay the bill in March. Expense are recognised in January.

The challenge is to find all expenses belonging to a period and "accrue" them; i.e., recognise them as expenses before paying for them. Many business consider the date on the invoice to be the date for expenses to be recognised, adjusting the numbers at year end only for invoices not yet received. Many businesses estimate accrued expenses.

Accrual issues

Once revenues and expenses are accrued, there is the possibility of double-counting: once in the accrual process and again when invoices are paid or funds are received. Many firms estimate accruals for revenue and expenses. This can become confusing and many firms maintain separate listings of all accruals.

For example, you may accrue an expense for January in a journal entry: Debit -- Postage expense Credit -- Accrued expenses- Liability

In February, the invoice is entered in the system: Debit -- Postage expense Credit -- Cash

There is a duplication in the postage expense account. Because of this problem, many businesses reverse accrual journal entries the following month, or when they are paid. If not, the correct way to book a transaction previously accrued is to debit accrued expenses and credit cash.

Benefits

Accrual accounting has the benefit of allowing you to plan ahead. If you are on cash basis, you won't have receivables and payables and you will not be able to plan your cash situation. By matching revenues with expenses, you get a much better idea of your profitability. For example, suppose you finished a project and you bill a client in March. The client pays you in April. If you're on accrual basis, you would recognise income in March, when all the expenses associated with that project occurred.

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