What is Accrual Accounting?
Published at : 12 Dec 2020
ZACH DE GREGORIO, CPA
In this video we are talking about accrual accounting. What I want is to get you to realize the beauty of this concept. This is one of those key concepts you have to understand if you are going to work in accounting or finance.
Let’s start with the definition. Accrual accounting reports financial statements based on economic events rather than when cash transactions occur. This means that if you issue a financial statement for one year, it should reflect what actually happens in a business during that year rather than simply the cash going in and out of your bank account.
This definition is so important to understand because most financial statements use accrual accounting. For instance, a company whose stock is publicly traded is required to have financial statements based on accrual accounting. The alternative is generate financial statements on a cash-basis, and many small businesses do this, because it is easier. You need to understand why larger companies use accrual accounting, and the benefits.
From a practical standpoint, here is what happens in a business.
1) Every month you close the books (or whatever period you issue financial statements)
2) You receive status updates from your project managers
3) Under accrual accounting, you perform “accruals.” Accruals are adjusting journal entries that adjust revenue and expenses to reflect economic activity rather than cash transactions
4) Publish your accrual financial reports
So you can see here that this is a lot of work, but you are communicating what is actually going on in your business.
So why do we use accrual accounting? Isn’t cash what is really important? After all, you want businesses to generate cash. I have even made another video about the “Statement of Cash Flows” and why it is so important to understand what is happening with your cash. So why do all this extra work. The answer has to do with capital markets. In a mature business, cash is only one element of owner’s equity that is funding your company. You have cash, debt, receivables, stock ownership. What capital markets really care about is productivity. They want to understand revenue and profit each period. They want to know what is actually going on the business. So accrual accounting communicates economic activity each period and reflects that activity in financial statements. What is so powerful is that accrual accounting is what makes capital markets possible. Without accrual accounting, people wouldn’t be able to look at companies and understand their level of productivity.
Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.