Accrual Accounting | Advantages & Disadvantages | Examples

Summary

In this tutorial, the concept of accrual accounting is explained, showcasing its significance in business financial reporting. The video covers how revenue is recognized when earned, and expenses are recorded when incurred, regardless of cash flow. Practical examples such as accounts payable, prepaid expenses, and accounts receivable illustrate the application of accrual accounting. The advantages, including accuracy, holistic financial views, and fewer errors, are contrasted with its complexity and maintenance challenges. This method is essential for larger businesses, ensuring a clear financial picture for investors and stakeholders.

Takeaways

• 😀 Accrual accounting recognizes revenue when a sale is made, regardless of whether the payment is received in cash or credit.
• 😀 Expenses under accrual accounting are recognized when they are incurred, not when they are paid.
• 😀 The accrual accounting method is based on the matching principle, where expenses are matched with the revenue they help generate.
• 😀 Accrual accounting provides a more accurate and holistic view of a company's financial health, including future revenues and expenses.
• 😀 It helps investors get a clear picture of a company's current financial status, even if cash hasn't been received or paid yet.
• 😀 Accrual accounting is typically used by medium to large businesses, especially those with higher cash flows and multiple transactions.
• 😀 Businesses earning over $5 million annually or corporations generally prefer accrual accounting for its accuracy in handling numerous transactions.
• 😀 Practical examples of accrual accounting include accounts payable (e.g., salaries) and prepaid expenses (e.g., wages).
• 😀 The accrual method allows businesses to record sales and profits from both cash and credit transactions, unlike cash accounting.
• 😀 The advantages of accrual accounting include increased accuracy, ease of information retrieval, and its recognition by the Companies Act.
• 😟 Disadvantages of accrual accounting include its complexity and the difficulty in maintaining accurate records, especially for large businesses with many transactions.

Q & A

What is accrual accounting?

Accrual accounting is an accounting method where revenues are recognized when earned, and expenses are recognized when incurred, regardless of when cash transactions occur.

How does accrual accounting differ from cash accounting?

In accrual accounting, revenues and expenses are recorded when they occur, not when cash is exchanged. In contrast, cash accounting only records transactions when cash is received or paid.

What is the matching principle in accrual accounting?

The matching principle in accrual accounting requires that expenses be recorded in the same period as the related revenues, ensuring that financial statements accurately reflect the company's financial position.

Why do businesses use accrual accounting?

Businesses use accrual accounting to get a more accurate and comprehensive view of their financial health, showing both cash and non-cash transactions. This helps investors assess the company’s current standing and future prospects.

What is the minimum revenue threshold for using accrual accounting?

The general guideline is that businesses with annual revenues over $5 million should use accrual accounting, as the volume of transactions justifies this more comprehensive method.

What is the first example of accrual accounting mentioned in the video?

The first example discussed is **accounts payable**, where a company owes salaries. Under accrual accounting, this transaction is recorded as both an expense in the income statement and a current liability in the balance sheet.

What is prepaid expense in accrual accounting?

A prepaid expense is a payment made in advance for goods or services. Under accrual accounting, prepaid expenses are recorded as assets and then expensed over time as the benefit is consumed.

Can you provide an example of prepaid expenses from the video?

An example from the video is Facebook, which reported prepaid expenses of $959 million and $659 million for 2016 and 2015, respectively.

How are accounts receivable treated under accrual accounting?

In accrual accounting, even if some sales are made on credit, they are still recorded as revenue. For example, if a business sells $1 million in goods and 40% is on credit, the credit sales are recorded as revenue, not just the cash sales.

What are the main advantages of accrual accounting?

The main advantages of accrual accounting include its holistic approach to recording both cash and non-cash transactions, higher accuracy due to the double-entry system, and compliance with legal requirements, making it suitable for larger businesses.

What are the disadvantages of using accrual accounting?

The disadvantages of accrual accounting include its complexity and difficulty in maintaining, especially for businesses with many daily transactions. It also requires more resources, such as dedicated accounting staff and software.