Accounting - The Accrual Basis
In accounting, the accrual basis means that a company should record revenue once it earned them and record expenses when they incurred. This accounting approach has an impact on the company’s balance sheet. This is because the accountant will record the accounts payable and accounts receivable related to specific transactions even though the company has not paid or received any cash.
For all sizable organisations, accrual basis is the standard way of recording transactions. Also, if business owners choose to outsource their accounting tasks, the accounting firms in Johor Bahru will suggest them to use this method too. The accrual basis is the opposite of the cash basis, where the companies that implement the latter will record revenues when they receive cash, and record expenses when they pay cash. As an instance, an entity which implements the accrual basis will record a sale once it issues the related invoice to its client. On the contrary, an entity that uses the cash basis will not record the sale until it receives the payment from the client. Similarly, a company that uses the accrual basis will record an expense as soon as it incurs. In contrast, a company that implements the cash basis will only record that expense when it pays its suppliers (Also see Differences Between the Accrual Basis and Cash Basis of Accounting).
Both IFRS and GAAP recommend the accrual basis of accounting. Both the accounting frameworks helps the companies in understanding the correct way for them to record their revenues and expenses without receiving or paying cash.
The accrual basis will provide more information about the recognition of revenue and expense transactions over time. Hence, the investors will think that this is the most reliable accounting system that helps them in determining the cash flow, financial position, as well as results of the operation of an entity. Also, it complies with the matching principle in accounting, which means that the company will record the revenues and all relevant expenses in the identical reporting period. Thus, the company can understand the profits and losses which are related to specific transactions in that reporting period.
As a business owner, if you choose to use the accrual basis, you need to do some estimates in some particular areas (Also see Financial Reporting Standard 8: Accounting Policies, Changes in Accounting Estimates and Errors). For instance, even though the estimated bad debt has not incurred, you need to record for the associated expense. If you do so, you will be able to record the expenses that are associated with a transaction for the revenue at the same time. As a result, the income statement of your company will show the results of its operations. Similarly, you can record the amount of obsolete inventories, the product that will be returned, as well as sales allowances that you predict. However, these estimates might not be accurate and may result in financial statements which are materially inaccurate. Thus, you must be very careful when you are estimating your company’s accrued expenses.
Small business owners may choose to avoid the accrual basis as they need to have an in-depth understanding of accounting if they want to implement it. Besides, they may want to change the timing of cash flow for both inflows and outflows so that they can reduce the amount of taxable income by using the cash basis. This enables them to postpone the payments for income tax.
A significant drawback of the accrual basis is that it may show that the company has earned a profit, although the related cash flow has not happened yet. As a result, a company which is assumed to be profitable may not have enough cash for its operation, and it may go bankrupt in spite of the profitability it has reported (Also see How to Calculate Return on Capital Employed (ROCE)?). Thus, as a business owner, you must also focus on your company’s cash flow statement, since from that, you will know clearly about the cash inflows and outflows of your business.