2. What is accrual accounting
What Is Accrual Accounting? Also called accrual basis accounting, the
accrual accounting method requires that transactions be recorded at the
time they occur in agreement – not at the time when cash is actually
received or spent.
Accrual Accounting (or Accrual Basis Accounting) for example.
Depending on the size of your organization, and whether it is privately owned
or publicly traded, the accrual accounting method might be required by the
Generally Accepted Accounting Principles (GAAP).
However, if you are just starting out, are not publicly traded, or have a smaller-
medium business, then it is up to you to decide which accounting method will
work best for you.
3. The Advantages of Accrual Accounting
1. It's Compliant With GAAP
Even if you are not yet required to use the accrual accounting method, one solid argument for establishing this practice
in your business now is that it is the method required by the GAAP.
As your company grows, you might eventually be required to switch over to accrual accounting in the future, so already
having this method in place and being accustomed to using it will put you at a significant advantage down the road.
2. It's More Transparent
Unlike the cash accounting method which only shows transactions as they happen – not as they're about to happen –
accrual accounting is much more transparent because it shows a business's accounts as they are about to be or truly
are, reflecting all of the money that will soon be coming in and all the payments that will soon be going out.
As a result, the accrual accounting method provides business leaders with a much clearer picture of a company's
financial health at any given time.
3. It Simplifies Strategic Planning
Since accrual accounting reflects certain future cash flow activities, it enables much better strategic planning.
With this accounting method, business owners can quickly identify when a cash flow shortage might be on the horizon
or when a cash influx is coming. As a result, accrual accounting allows you to better plan ahead to prevent crises as a
result of unforeseen shortages and to be prepared to make the most of upcoming windfalls.
4. The Disadvantages of Accrual Accounting
1. It Can Be Challenging
Cash accounting is straightforward: record expenses as they go out and record income as it comes in. Accrual
accounting, on the other hand, is not so straightforward. There are several rules that need to be followed and a
consistent process must be established for defining when and how to record certain types of expenses and income.
Additionally, tax forms can be slightly more complicated to complete when using the accrual accounting method. [2]
2. It Can Be Difficult to Switch to Accrual
If you are already using a different accounting method in your business, switching over to the accrual method can be
challenging. For example, having cash flow issues can exacerbate this challenge. That being said, cash flow
improvement and transparency are important reasons why businesses should use the accrual method.
3. It Can Leave You Vulnerable to Fraud
If you are handling your business's finances on your own or with a few back-office employees, the accrual accounting
method can open your business up to the potential for fraud. To safeguard your company from internal fraud and to
ensure your financial statements are always accurate, it's essential to have proper systems of control in place –
especially, if you do not feel fully comfortable evaluating the company's ledgers and understanding the accrual
accounting method.
5. Transactions and Balances
Accounting consists of accounting transactions and balances. Transactions are
financial events such as issuing an invoice or receiving payment, whereas balances
are stores of value. This value can either be actual money, such as the bank balance,
or the estimated value of non-monetary things. As we progress through this course
we will explore what some of these things are.
Recall the example from the previous lesson about running a business that sells
oranges to a supermarket chain. You are going to use an interactive model to
simulate doing this, but first watch this video that explains the accounting analogy
and how to use the model.
6. What’s the Difference Between Cash Flow and
Revenue?
Revenue Cash Flow
Financial statement Income Statement Cash Flow Statement
What it measures The dollar amount of
sales the firm generates
through marketing or
other activities
The cash generated by
operating, investing, and
financing activities of the
firm
What it means Revenue must always
remain greater than
expenses for a healthy
firm.
Cash flow must always
remain positive or the
firm does not have the
money to operate.
Accrual or cash
accounting
Revenue is reported on
an accrual basis. Sales
have been made that are
not yet paid for.
Cash flow is reported on
a cash basis. It is the cash
that moves into and out
of the firm.
8. Summary of Assets vs. Liabilities
Assets are the purchases an organization makes to improve their financial position
or assist in their operations. Liabilities are the amounts a company owes to external
entities.
Assets and liabilities are both taken into consideration to reflect the true financial
position of a company.
The assets of a company are also used to determine the credit scores of a company
among other factors.
Comparisons within different firms can also be done accurately with the balance
sheet that displays both the assets and liabilities.
Assets include land, buildings, plant and machinery, inventory and can all easily
depreciate in value. Liabilities include loans, debentures, accounts payables and
can’t depreciate.
9. Double-Entry Bookkeeping
When running the model you will now notice that every flow starts and ends in a
tank. This means that every accounting transaction "comes out" of one balance
and "goes into" another. This is a general principle of accounting called the
principle of double-entry bookkeeping. At the end of this lesson we will look at
how this is linked to debiting and crediting.
Another thing you may have noticed in the model is that every balance is initially
zero. This corresponds directly to the fact that when a business is created every
balance is zero. Every subsequent transaction in the business will fill one tank and
drain another.
10. Assets, Liabilities & Equity
Assets = Liabilities + Equity
A good way to think about the equation is to think that everything that a
business owns (its assets) it also owes (its liabilities and equity). The amounts owed
are a combination of actual legal debts to employees or suppliers, and the profit
that a business has generated which from an accounting perspective is owed back
to the company's owners.
This equation is called the Fundamental Equation of Accounting. As we have seen
using the model, it is a simple result of double-entry bookkeeping and the initial
value of zero for every balance.
