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Accrual accounting

A method of accounting that recognizes revenue when it is earned and realizable, regardless of when the cash is received, and recognizes expenses when the related revenue is recognized, rather than when the cash is paid.

Main Points:

  • Accrual accounting follows the matching principle, which means that revenue and expenses are reported in the same period to determine profits and losses.
  • It is different from cash accounting, which only records transactions when cash is exchanged.
  • Accrual accounting considers both current and expected cash flows, providing a more accurate understanding of a company's financial status.
  • It captures all business transactions, not just those involving cash.
  • It is particularly useful for complex transactions involving credit, prepayments, and future payments, as it ensures proper recognition of revenues and expenses, which can significantly impact a company's perceived financial performance.

For example, suppose that a company called ABC Inc. provides consulting services to a client in March, and the client agrees to pay for the services in April. 

Under the accrual method of accounting, ABC Inc. would recognize the revenue from the consulting services in March, when the services were provided, even though the money has not yet been received. 

The transaction would be recorded in the company's general ledger as a credit to the consulting services revenue account and a debit to the accounts receivable account.

Once April arrives and the client pays the invoice, the accounts receivable account would be reduced by the amount of the payment, and the cash account would be increased by the same amount.

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