You may have read my previous musings on financial accounting and my feelings on the subject. Apparently, Accountants have a name for what I thought accounting should be like, it is called “Cash Basis Accounting”. However, they (accountants) came together and agreed that it was not a reasonable way to present your books and came up with a concept called “Accrual basis of accounting”.
Accrual basis is an accounting concept used to record revenue and expenses in a company’s Financial Statements. Accruals refers to either revenues or expenses that have been earned or incurred but cash has not been received or paid. For example, interest on loans that has not yet been paid, or services that have been executed and the revenue earned, but the customer has not yet paid or been billed. Another simple representation will be, if a company provides services to a customer in December but does not receive payment until January, it means the revenue was earned in December and it would be recorded as an accrual in December as against waiting to record it when the cash is received in January.
While this accounting concept is not new to me as I had heard the term used several times prior to now, I had not fully understood the importance and implication until now. Over the past few weeks I have come to learn and understand the importance of the accrual basis of accounting, some of which I will explain below.
- Compliance with Generally Accepted Accounting Principles (GAAP)and International Financial Reporting Standards (IFRS)-These standards require that revenue is recorded when it is earned, and expenses are recorded when they are incurred irrespective of when cash changes hands. if everyone was reporting or presenting their accounts in several different ways according to whatever basis or styles they chose per time, it would lead to chaos in the system and very likely misrepresentation of financial positions and fraudulent practices.
- Informed Decision Making- This uniform practice ensures that investors or anyone looking at the financial statements of a company can make accurate and informed decisions regarding a company. Imagine if a company does not record expenses it has incurred in one period and then records all the revenue it has received, it means that the income realised by the company will be overstated and any investor seeing that financial statement will be mislead about the true financial performance or position of that company.
- The Accrual basis of accounting therefore makes for accurate and uniform basis of reporting of financial transactions.
These accruals are then recorded as something called “adjusting entries” at the end of the accounting period to ensure that the financial statements accurately reflect the company’s financial position and performance. Since they ensure that expenses and revenues are properly matched to the appropriate accounting period, which is important for making informed business decisions. Having taken time to understand the basis of this concept, I can finally agree with the accountants and say they are on to something.
SELF- LEADERSHIP