Accrual Accounting - dummies

By Kenneth Boyd, Lita Epstein, Mark P. Holtzman, Frimette Kass-Shraibman, Maire Loughran, Vijay S. Sampath, John A. Tracy, Tage C. Tracy, Jill Gilbert Welytok

An effective budget applies the matching principle. The principle states you should match the timing of the expenses of creating and delivering your product or service with the timing of getting revenue from the sale. This is accrual basis accounting (as opposed to cash basis accounting). Accrual accounting ensures that revenue is more precisely matched with the expenses incurred to generate revenue.

With accrual accounting, when you create an invoice, the accounts receivable (A/R) system generates a receivable, even though the customer may not pay for, say, 30 days. When the payment arrives, the receivable is adjusted to zero, meaning it’s been satisfied by the payment.

Accrual accounting is considered to provide a more accurate reflection of business activity than cash accounting. By the way, the system still allows for straight cash sales — where you sell now and the customer pays now.

The same is true of purchases you make. When you buy now and pay later, you create a payable. When the bill comes and you pay it, the payable is adjusted to zero. Of course, the system allows you to make straight cash purchases — where you buy and pay your vendor now.

Suppose you manage a catering business. The food, preparation cost, and delivery expenses related to the Jones family reunion should be matched with the revenue from the Jones family.

Ideally, you want the expense and the revenue to be posted in the same time period. You wouldn’t want the Jones expenses posted in March and the Jones revenue posted when they paid (say, in April). That’s not the best reflection of your business activity.

The downside of accrual accounting is that your income statement revenue and expenses rarely match your cash inflows and outflows. You can be rich in receivables and darned poor in cash. But most companies still prepare a cash flow statement even if they’re using accrual accounting.