Accrual accounting is a system of accounts record keeping whereby revenue earned and losses incurred, but no cash has actually changed hands yet.
It is in contrast with the cash flow accounting method of record keeping where only cash that has changed hands are accounted for without consideration for receivables and payables.
It is not uncommon for companies to prepare account statements using both methods to have an overview of the performance of the business. Judging where is the middle that shows the true financial status of the company is the challenge that every company undertakes.
Why accrual accounting?
The main benefit of accrual accounting is that it shows the amount of money that the company can look forward to collecting in the near future, and the amount of expenses that would have to be paid in the short term as well.
Accrued revenue is an indication of how strong a business is in it’s markets.
For example, even though a business might have $10,000 in the bank, an analyst would not be able to evaluate the company’s true financial performance when $100,000 accrued revenue in the form of accounts receivables are scheduled to be collected next month.
In the same sense, a business might look financially strong and healthy when it has a $50,000 balance in the bank. But when it is taken into account that there is a $100,000 expense that would be payable in the following month, the outlook might not look as good.
This can be especially critical information for seasonal businesses.
A company might have a seemingly dormant business with little transactions in the current month. But revenue generated for a season product or service might mean income that would be collected in the following few months ahead.
If any, most prudent business analyst would look into the accruals that a company has on it’s books when conducting business performance assessment. This is especially so for acquisitions and mergers.
Should a balance be prepared, then accrued receivables would be recorded as short term or current assets. Accrued expenses would be recorded as short term of current liabilities.
In the odd occurrence that accrual items take more than a year to realize then they might not be listed as current items.
Drawbacks of accruals
While the pragmatic accountant or analyst would find that accruals are material items that indicate the true financial position of a company, it must be noted that the assumed results from accruals might never materialize.
For example, there is no guarantee that sales income that is owed by a customer would eventually be paid. In fact, if an account has been due for a long period of time, then there is every possibility that the debtor would not repay.
Thus, it is not uncommon for receivables to be categorized as bad debt by management after a certain period of time.
This period of time has to be determined by management as there is no industry standard.
However, the longer accounts receivable remains unpaid, they essentially represent free financing on the part of vendors. This is assuming that there are no interest charged.
The main drawback of accrual accounting is the reason why cash flow statements are often seen as data that are more dependable for investors.
