With accrual basis accounting, a firm recognizes revenues when a sale occurs regardless of when the firm receives payment for the sale. Likewise, a firm recognizes expenses when it incurs the expense, regardless of when the firm sends payments to its vendors.
The accrual method has two advantages over the cash method. First, the accrual method better matches revenues and expenses. This gives more meaning to the income statement as it provides better information about a period’s operations.
The second benefit of the accrual method is that it provides a more accurate description of the firm’s financial position.
With double-entry bookkeeping, every transaction affects two or more accounts. On a cash basis, each revenue and expense transaction have a corresponding debit or credit to a cash account. With accrual basis accounting, however, revenues for which payment has not yet been received are offset with an asset account called accounts receivable. The entry for recognizing such a sale on the accrual method is as follows:
Debit Accounts Receivable ; Credit Sales
Likewise, an expense which has been incurred but not yet paid for is offset with a liability account called accounts payable. The entry for recognizing such a sale on the accrual method is as follows:
Debit Expense (or Inventory) ; Credit Accounts Payable
The accrual method has two drawbacks. First, the accrual method may lead to a higher tax liability than if the cash method was used. Second, the accrual method is more involved and will require more time and accounting knowledge to implement. However, the accrual method provides a more accurate financial picture for the firm.
