Accrual Accounting
We would have heard the terms, cash basis accounting and accrual accounting many times. What do these terms mean? Let’s have a quick and simple look at them.
The cash basis of accounting recognises revenues when cash is received, and expenses when they are paid. This method does not recognise accounts receivable or accounts payable.
Whereas accrual accounting is a method of accounting where revenues and expenses are recorded when they are earned, regardless of when the money is actually received or paid
To understand accrual accounting, let's first understand what we mean when we say the word 'accrual'. Accrual refers to an entry made in the books of accounts related to the recording of revenue or expense paid without any exchange of cash.
The use of accrual accounting is typically useful in businesses where there are a lot of credit transactions or the goods and services are sold on credit, which simply means that there was no exchange of cash.
If you sell your goods or products on credit, the sale is recorded in the books based on the invoice generated. There is a possibility that you may not have received the payment by cash at that particular point in time.
An expense is occurred or recorded when the raw material is ordered and not when the actual payment is made to the supplier by either cash or cheque. The only drawback of this type of accounting system is that you, as a firm, might end up paying tax on revenues even when you might have not received it (credit).
The plus-side is that the accrual basis gives a more realistic idea of income and expenses during a period of time, therefore providing a long-term picture of the business that cash accounting can’t provide.
The minus-side is that accrual accounting doesn’t provide any awareness of cash flow; a business can appear to be very profitable while in reality it has empty bank accounts. Accrual basis accounting without careful monitoring of cash flow can have potentially devastating consequences. Satyam Computers crisis is worth pointing here.
10-09-2020