Accrual accounting recognizes revenue when it is earned and expenses when they are incurred, regardless of whether cash has been exchanged. This method provides a more accurate representation of a company’s financial position as it reflects economic activity during a given period. For example, if a business completes a service for a customer in January but does not receive payment until February, accrual accounting would recognize the revenue in January. Accrual accounting involves recognizing revenue and expenses when they are incurred, regardless of when the cash is actually received or paid.
Most companies regard accrual-basis accounting as standard practice because of the fiscal clarity this system provides — a major benefit at tax time and always. The Internal Revenue Service (IRS) allows any small business with less than $25 million in annual revenue to choose its accounting method. Once they choose, however, that company can not deviate from the system they choose.
What does accrual basis mean?
This allows for a look at the contrast between accruals and deferrals within those Revenue and Expense transactions. Allocating the income to sales revenue may not seem like a big deal for one subscription, but imagine doing it for a hundred subscriptions, or a thousand. The earnings would be overstated, and company management would not get an accurate picture of expenses vs revenue.
By creating an accrual entry for this expense in December, you can accurately reflect the full cost of those goods on your year-end financial statements. An adjusting entry to record a Expense Deferral will always include a debit to an expense account and a credit to an asset account. An expense deferral occurs when a company pays for goods or services in advance of the goods or services being delivered. (Cash comes before.) When a prepayment is made, we increase a Prepaid Asset and decrease cash. That Prepaid Asset account might be called Prepaid Expenses, Prepaid Rent, Prepaid Insurance, or some other Prepaid account. It’s an asset because if company does not receive the benefit of what it has paid for, it would receive cash back (for example an insurance policy refund).
Which approach is best for your business?
The cash basis is very easy to use, and generally, there is not much complexity involved in it as simply a record of the transaction only when the cash is received in the business. Due to the simple nature of accounting, small businesses often use cash basis to prepare their books of accounts. It should be noted that in relation to expenses the term deferral is often used interchangeably with the term prepayment.
