Legal Definitions - accrual method of accounting

The accrual method of accounting is a financial reporting system that recognizes revenues when they are earned and expenses when they are incurred, regardless of when cash actually changes hands. This means that a business records income as soon as it has provided goods or services and has a fixed right to receive payment, even if the customer hasn't paid yet. Similarly, it records expenses as soon as it has received goods or services or incurred an obligation, even if it hasn't paid the supplier or vendor yet.

This method provides a more accurate and comprehensive picture of a company's financial performance and obligations over a specific period, as it matches revenues with the expenses incurred to generate those revenues. It is widely used by larger businesses and is often required by regulatory bodies like the Internal Revenue Service (IRS) for companies exceeding certain revenue thresholds, because it better reflects the true economic activity and financial health of complex operations compared to the cash method of accounting, which only records transactions when cash is received or paid.

Here are a few examples to illustrate the accrual method:

• Example 1: Service Income Recognition

  Imagine a web design company, Digital Canvas Studios, completes a new website for a client in December. They send an invoice for $8,000 to the client on December 28th, but the client's payment terms allow them 30 days, so the payment isn't received until January 25th of the following year.

  • Under the accrual method, Digital Canvas Studios would record the $8,000 as revenue in December. This is because the service was fully delivered in December, and the company has a fixed right to receive that income, even though the cash hasn't arrived yet.
  • This example illustrates how the accrual method focuses on when the economic activity (providing the service) occurs and when the right to payment is established, rather than waiting for the physical receipt of cash.

• Example 2: Expense Recognition for Inventory

  Consider Fresh Foods Market, a grocery store. In March, they receive a large shipment of produce from a supplier, along with an invoice for $3,000. The invoice states that payment is due by April 15th, but Fresh Foods Market pays the supplier on April 10th.

  • Using the accrual method, Fresh Foods Market would record the $3,000 expense (for the inventory received) in March. This is because the obligation to pay for the goods was incurred and fixed in March when the produce was delivered, even though the actual cash payment happened later in April.
  • This demonstrates that the accrual method recognizes expenses when the liability is created and the goods or services are received, providing a clearer view of the company's obligations at that time, irrespective of the cash outflow date.