Accrual Based Accounting

Accrual based accounting refers to the method used to report earnings and income over the fiscal accounting reporting period.  For many legal entities, such as C corporations and governments, that year ends on September 30th of each year.  For the rest of us, those years ends as the physical year ends, on December 31st each year.

What do we mean when we use the term "accrual" basis for accounting?  Accrual-based accounting means that sales are recorded when the sale occurs; it doesn't matter when the money is actually received.  For many government agencies, the accrual based accounting system has never been used, but thanks to fact that governments and other public sector entities are using private sector type financial statements, there may be a shift in accounting methods, even for the government.

There are basically two forms of accounting methods: cash and accrual.  Cash based systems are great if your income is below one million, and you don't have problems collecting for your products or services.  Well, by that definition alone, many of today's businesses should not even consider the cash based accounting methods.

What benefit does accrual based accounting provide?  Actually, quite a few if you happen to be a mid-sized business and you need to keep an accurate picture of your company's profitability on a regular basis.  A few of the additional benefits are: greater focus on the business output, not the input; more cost-effective and efficient use of resources; the full cost of providing your product or service can be compared across industry standards; improved accountability and better financial management, just to name the most common.

What benefit does the government hope to gain, since profitability isn't an issue?  This method of accounting also provides the business with a better perspective of management performance and results.  What does that mean for government?  It's a new viewpoint in comparing how our government measures up against private sector businesses, and produce better management and efficiency from the public sector of the business world.

The greatest advantage to accrual based accounting is that it allows an information manager, or if you're a small business, the business owner to accurately assess whether or not the business is generating a profit.  You can better assess profit levels because you match income to expenses, accurately when you use the accrual based method of accounting.

Compare this to the use of your credit card.  Suppose you use your credit card to purchase an item.  You don't actually have a deduction of your personal checking account until you pay for the credit card debt; this is cash accounting methods.  If you use your credit card, and then write a check immediately to satisfy that debt on your credit card, regardless of the due date of the bill, you're using accrual based accounting.  Can you see how accrual forces accountability, and also makes you aware of your spending limits?

For some businesses, there is a need to be able to view finances from both pictures.  Access to both methods provides information managers with a better view of actual cash flows, and keeps CEOs and CFOs more aware of the actual state of the business.

Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.