18 Nov 2021 20:00 IST

Accrual accounting: How it works and why it’s important

By recording accruals, a company can keep track of its cash flows accurately and systematically.

Managing performance is the core to success, whether it is a for-profit or not-for-profit entity. That would imply proper books of accounts are maintained of the business transactions. The two primary methods of accounting are accrual accounting (mandatory for companies) and cash accounting (generally used by individuals). The difference between them boils down to the timing of when a transaction is recognised and recorded in the books as either revenue or expenses.

In cash accounting, as the name signifies, transactions are recognised only if there is a receipt of funds or payment to the vendor. The matching concept, or matching principle, on the other hand, is the core of accrual accounting, and a fundamental element of it.

Cash vs accrual

Life is simple and straightforward in cash accounting where transactions are recorded in the books only upon receiving a receipt for income and pay out of cash for recording expenditures. In case the items are being sold on credit, the revenue will not be recorded until the receipt of cash payment under cash accounting. Sole proprietorships, professional firms, such as accountancies and law firms, and small services companies normally use a cash-basis accounting system. In accrual accounting, recognition of revenue or expenditure will be whenever you earn/incur it, regardless of the cash flow.

Recognition under accrual accounting

The accrual basis of accounting recognises revenues, expenses, gains, and losses, and the related increase or decrease in assets and liabilities, in the period when the transaction occurs. It relies on revenue recognition and matching principles which consider the timing of the recognition of business transactions and events.

Recognition is the process of formally recording a business transaction or event in an entity’s financial accounting records. The realisation is the process of converting non-cash resources and rights into money, which is achieved through the sale of an asset for cash or converting claims to cash. While recognition is the act of recording a business transaction or event, realisation establishes the completion of earning process and is synonymous with cash inflow or outflow.

The cash basis of accounting considers the realisation of — and the resulting cash flow from — a transition or event.

Matching concept

The matching concept exists only in accrual accounting. This principle requires  matching of revenues with the expenses incurred  directly for the purposes of the revenues earned, and  reporting both at the same time. Expenses are costs that a business incurs to generate revenue. The matching principle states that a business must record the expenses it incurs in the same accounting period as the revenue to which those expenses contribute, even though a business may pay for those expenses at a later point of time. The result is that a company’s reported expenses typically differ from the amount of cash paid for expenses in a particular period.

When a business purchases raw materials on a credit basis from a supplier, then the entry in the books of accounts will be recorded on the invoice  date or on the date of the receipt for the raw materials, as the case may be and not at the time when the owner pays the amount to the supplier. Suppose X Ltd purchased raw material worth ₹10,000 from its supplier on October 1, 2021, but the payment for the same is made on November 15, 2021, the purchase expenditure will be booked in the accounts of  X Ltd as on October 1, 2021, based on the principles of accrual concept. Suppose the same material was sold on October 10, 2021 for ₹12,000 and the payment was immediately received, in the absence of accrual accounting, the company would have made sales without any corresponding purchase expenditure, and that would give a wrong picture of profitability.

Making the choice

Under cash accounting, the business of the company would incur various expenses but would not recognise revenue until actual cash inflow is received from the customer. The accounting records of the company would look uncertain until the actual revenue realisation.  For a company, which is looking for debt financing from a bank, for example, the cash accounting method makes it look like a poor bet because it is incurring expenses without revenue being  recognised. In simple terms, cash accounting methodology is commonly used by individuals to track daily activities and small business activities.

However, it is mandated by statute that all the corporates and large-scale businesses follow accrual method of accounting to envisage the true and fair position of business activity in line with the matching concept and prudence principle.

Investors, creditors and lenders will want to see financial statements prepared in accordance with widely-accepted accounting principles that mandate accrual accounting, including the use of matching concept.

(The writer is Partner, RVKS And Associates.)