An example of an accrual accounting method is the rental of a storefront. A clothing retailer pays $2,500 per month for rent on the first day of the month. However, they do not receive payment until they have provided the services they promised. This is because they pay quarterly and don’t receive their bill until the end of March. The expense is recorded as an accrued expense in January even though the landlord may not have actually provided the services yet.
In the case of an appliance store, a customer can purchase a refrigerator on credit and it may take several months or even years for them to pay the full amount. Using an accrual accounting method, the retailer would record the revenue on the day that the refrigerator leaves the store. Because of this, the IRS does not require companies to use accrual accounting, but it does not hurt to use this method. It is an accurate way to keep track of a business’s financial records.
With accrual accounting, revenues and expenses are recorded on the date of sale. This means that the sale of a product on credit will be recognized in the books on the date of sale. For example, a company should record an expense for estimated bad debts. It should also record expenses associated with a revenue transaction, such as a product return or sales allowance. However, the company should avoid a practice known as this because it can lead to inaccurate financial statements.
As you can see, accrual accounting uses double-entry bookkeeping, which means that every transaction will be recorded twice. This will make it easier for the accountants to determine the value of an asset and deduct any associated liability. For the sake of simplicity, this method is used in small business situations, which may not have the resources to hire an accountant. But it is an effective method for keeping track of cash inflows and outflows.
Businesses that use the accrual method should keep full documentation of adjusting entries. This will help reviewers understand why the entries were made. Additionally, adjusting entries should be set to reverse in the next period. That way, the process will eliminate stray entries from the system. If a company uses cash basis accounting, the payment is recorded in cash as soon as it is received. If the payments are not made in time, the business must wait until the payment period is completed to record revenue and expenses.
An accrual accounting method also has limitations. A company should make an accrual-based income statement. The income statement should be as accurate as possible to ensure the accuracy of the figures. A cash-based income statement is a better reflection of the business’s overall performance. This is because the revenue from the accrued income will be recorded at the same time as the expenses. This way, an organization’s profit and loss will be more comparable to other similar-sized companies in the same industry.