Accounting Basics

The accrual accounting method is a method of managing the accounting of a business in which transactions are recorded at the time they take place even if an exchange of assets has not taken place between the entities involved in the transaction, i.e. payment for the goods sold or services provided was not yet received by the seller and wan not yet made by the buyer. This method is based on the basic accounting principle called the matching principle, i.e. when it is necessary to match revenue with expenses incurred to earn such revenue.

How is the Accrual Accounting Method Used?

The basis of the accrual method of accounting dictates that as soon as a document, such as a billing statement or sales receipt, which supports the assumption that a debit or credit transaction has taken place, the accountant makes an entry into the appropriate accounts to represent the transaction. Of course, if cash or other property is exchanged between the entities involved in the transaction at the time the transaction initially takes place, such as a purchase made in a retail store, then the transaction would be recorded at that time regardless of the accounting method being applied.

What are the Benefits of Using the Accrual Accounting Method?

With the accrual accounting method, since liabilities are accounted for as soon as they is a legal basis for them to occur, it is less likely that a business will fail to allocate assets to cover the liabilities due to an accounting error. Also, since using accrual accounting means that assets, liabilities and revenues are recorded in chronological order, accrual accounting allows transactions to be evaluated easily and efficiently. In addition the accrual method of accounting provides more accurate financial position of the business. However, the accrual method does require that more entries are made into the accounts and since transactions are recorded despite whether cash for goods sold or services provided is received or not, in case customers fail to pay their debts, such debts will have to be recorded as losses. This is a good practice, as financial statements will indicate quality of accounts receivable and losses incurred on sales to non-paying customers.
We can conclude that this method of accounting is more widely used and recommended accounting method.

Example of the Accrual Accounting Method

The company ABC on May 2, 2009 signs an agreement with the company XYZ to sell 1000 chairs. The chairs are delivered to the warehouse of the company XYZ on May 3, 2009 and the ownership title to the chairs is transferred to this company at the delivery time. Applying accrual accounting method company ABC in its books will record the transaction on May 3, 2009, when the chairs were delivered to the customer, i.e. recording sales revenue and accounts receivable from the company XYZ, reduce value of inventory by the cost on inventory sold and reflect cost of sales as the expenses related to the sales income of chairs, despite the payment for the goods will be made later.
Applying the same method of accounting, company XYZ will record purchase of chairs in its books, i.e. increasing inventory value and recording liability (accounts payable) to the company ABC.
Thus both companies will have to record this transaction on the date, when ownership title to the goods was transferred from the seller to the buyer, despite the date when actual payment will be made.

Glossary of Common Accounting Terms

ACCOUNTING EQUATION: The Balance Sheet is based on the basic accounting equation. Assets = Equities.
Equity of the company can be held by someone other than the owner. That is called a liability. Because we usually have some liabilities, the accounting equation is usually written...
Assets = Liabilities + Owner's Equity.
ACCOUNTS: Business activities cause increases and decreases in your assets, liabilities and equity. Your accounting system records these activities in accounts. A number of accounts are needed to summarize the increases and decreases in each asset, liability and owner's equity account on the Balance Sheet and of each revenue and expense that appears on the Income Statement. You can have a few accounts or hundreds, depending on the kind of detailed information you need to run your business.
ACCOUNTS PAYABLE: Also called A/P. These are bills that your business owes to the government or your suppliers. If you have 'bought' it, but haven't paid for it yet (like when you buy 'on account') you create an account payable. These are found in the liability section of the Balance Sheet.
ACCOUNTS RECEIVABLE: Also called A/R. When you sell something to someone, and they don't pay you that minute, you create an account receivable. This is the amount of money your customers owe you for products and services that they bought from you...but haven't paid for yet. Accounts receivable are found in the current assets section of the Balance Sheet.
ACCRUAL BASIS ACCOUNTING: With accrual basis accounting, you 'account for' expenses and sales at the time the transaction occurs. This is the most accurate way of accounting for your business activities. If you sell something to Mrs. Fernwicky today, you would record the sale as of today, even if she plans on paying you in two months. If you buy some paint today, you account for it today, even if you will pay for it next month when the supply house statement comes. Cash basis accounting records the sale when the cash is received and the expense when the check goes out. ASSETS: The 'stuff' the company owns. Anything of value - cash, accounts receivable, trucks, inventory, land. Current assets are those that could be converted into cash easily. (Officially, within a year's time.) The most current of current assets is cash, of course. Accounts receivable will be converted to cash as soon as the customer pays, hopefully within a month. So, accounts receivable are current assets. So is inventory.
Fixed assets are those things that you wouldn't want to convert into cash for operating money. For instance, you don't want to sell your building to cover the supply house bill. Assets are listed, in order of liquidity (how close it is to cash) on the Balance Sheet.
BALANCE SHEET: The Balance Sheet reflects the financial condition of the company on a specific date. The basic accounting formula is the basis for the Balance Sheet:
Assets = Liabilities + Owner's Equity
The Balance Sheet doesn't start over. It is the cumulative score from day one of the business to the time the report is created.
CASH FLOW: The movement and timing of money, in and out of the business. In addition to the Balance Sheet and the Income Statement, you may want to report the flow of cash through your business. Your company could be profitable but 'cash poor' and unable to pay your bills. A cash flow statement helps keep you aware of how much cash came and went for any period of time. A cash flow projection would be an educated guess at what the cash flow situation will be for the future.
Suppose you want to buy a new truck with cash. But that purchase will empty the bank account and leave you without any cash for payroll! For cash flow reasons, you might choose to buy a truck on payments instead.
CHART OF ACCOUNTS: A complete listing of every account in your accounting system. Think of the chart of accounts as the peg board on which you hang the business activities.
CREDIT: A credit is used in Double-Entry accounting to increase a liability or an equity account. A credit will decrease an asset account. For every credit there is a debit. These are the two balancing components of every journal entry. Credits and debits keep the basic accounting equation (Assets = Liabilities + Owner's Equity) in balance as you record business activities.
DEBIT: A debit is used in Double-Entry accounting to increase an asset account. A debit will decrease a liability or an equity account. DIRECT COSTS: Also called cost of goods sold, cost of sales or job site expenses. These are expenses that include labor costs and materials. These expenses can be directly tracked to a specific job. If the job didn't happen, the direct costs wouldn't have been incurred. (Compare direct cost with indirect costs to get a better understanding of the term.) Direct costs are found on the Income Statement, right below the income accounts.
Income - Direct Costs = Gross Margin.
DOUBLE-ENTRY ACCOUNTING: An accounting system used to keep track of business activities. Double-Entry accounting maintains the Balance Sheet: Assets = Liabilities + Owner's Equity. When dollars are recorded in one account, they must be accounted for in another account in such a way that the activity is well documented and the Balance Sheet stays in balance.
You may not need to be an expert in Double-Entry accounting, but the person who is responsible for creating the financial statements better get pretty good at it. Study the examples and see how the Double-Entry method acts as a check and balance of your books.
EQUITY: Funds that have been supplied to the company to get the 'stuff'. Equities show ownership of the assets or claims against the assets. If someone other than the owner has claims on the assets, it is called a liability.
Total Assets - Total Liabilities = Net Equity
This is another way of stating the basic accounting equation that emphasizes how much of the assets you own. Net equity is also called net worth.
EXPENSE: Also called costs. Expenses are decreases in equity. These are dollars paid out to suppliers, vendors, Uncle Sam, employees, charities, etc. Remember to pay bills thankfully, because it takes money to make money. Expenses are listed on the Income Statement. They should be split into two categories, direct costs and indirect costs. The basic equation for the Income Statement is:
Revenues - Expenses = Profit
(You'll see a profit if there are more revenues than expenses!...or a loss, if expenses are more than revenues.)
Remember, all costs need to be included in your selling price. The customer pays for everything. In exchange, you give the customer your services. FINANCIAL STATEMENTS: refer to the Balance Sheet and the Income Statement. The Balance Sheet is a report that shows the financial condition of the company. The Income Statement (also called the Profit and Loss statement or the 'P&L') is the profit performance summary.
Financial Statements can include the supporting documents like cash flow reports, accounts receivable reports, transaction register, etc. Any report that measures the movement of money in your company.
Financial Statements are what the bank wants to see before it loans you money. GENERAL LEDGER: Once upon a time, accounting systems were kept in a book that listed the increases and decreases in all the accounts of the company. That book was called the general ledger. Today, you probably have a computerized accounting system. Still, the general ledger is a collection of all Balance Sheet and Income Statement accounts...all the assets, liabilities and equity. It is the report that shows ALL the activity in the company. Often this listing is called a detail trial balance on the report menu of your accounting program. The detail trial balance is my favorite report when I am trying to find a mistake, or make sure that we have entered information in the right accounts.
GROSS PROFIT: This is how much money you have left after you have subtracted the direct costs from the selling price.
Income - Direct Costs = Gross Profit. When this is expressed as a percentage, it is call Gross Margin.
The higher the better with gross margin! INCOME STATEMENT: also called the Profit and Loss Statement, or P&L, or Statement of Operations. This is a report that shows the changes in the equity of the company as a result of business operations. It lists the income (or revenues, or sales), subtracts the expenses and shows you the profit J! This report covers a period of time and summarizes the money in and the money out.
The Income Statement is like a magnifying glass that shows the detail of activities that cause changes in the equity section of the Balance Sheet.
INDIRECT COST: Also called overhead or operating expenses. Indirect costs include office salaries, rent, advertising, telephone, utilities...costs to keep a 'roof overhead'. Every cost that is not a direct cost is an indirect cost. Indirect costs do not go away when sales drop off.
INVENTORY: Also called stock. These are materials that you purchase with the intent to sell, but you haven't sold them yet. Inventory is found on the balance sheet under assets. Beware of turning cash into inventory. You may run out of cash. Work with your suppliers to keep inventory SMALL.
JOURNAL: This is the diary of your business. It keeps track of business activities chronologically. Each business activity is recorded as a journal entry. The Double-Entry will list the debit account and the credit account for each transaction on the day that it occurred. In your reports menu in your accounting system, the journal entries are listed in the transaction register.
LIABILITIES: Like equities, these are sources of assets - how you got the 'stuff'. Notes payable, taxes payable and loans are liabilities. Liabilities are categorized as current liabilities (need to pay off within a year's time, like payroll taxes) or long term liabilities (pay-back time is more than a year, like your building mortgage).
MONEY: Also called moola, scratch, gold, coins, cash, change, chicken feed, green stuff, BLING, etc. Money is the form we use to exchange energy, goods and services for other energy, goods and services. Beats trading for chickens in the global marketplace.
NET INCOME: Also called net profit, net earnings, current earnings or bottom line. After you have subtracted ALL expenses (including taxes) from revenues, you are left with net income. The word net means basic, fundamental. This is a very important item on the income statement because it tells you how much money is left after business operations. Think of net income like the score of a single basketball game in a series. Net income tells you if you won or lost, and by how much, for a given period of time.
By the way, if net income is a negative number, it's called a loss. The net income is reflected on the Balance Sheet in the equity section, under current earnings (or net profit). Net income results in an increase in owner's equity. A loss results in a decrease in owner's equity.
RETAINED EARNINGS: The amount of net income earned and retained by the business. If net income is like the score after a single basketball game, retained earnings is the lifetime statistic. Retained earnings is found in the equity section of the Balance Sheet. It keeps track of how much of the total owner's equity was earned and retained by the business versus how much capital has been invested from the owners (paid-in capital).
Each month, the net profits are reflected in the Balance Sheet as current earnings. At the end of the year, current earnings are added to the retained earnings account.
Ellen Rohr is the President and Founder of Bare Bones Biz, a business training and consulting company that teaches clients how to turn big ideas into successful businesses. Rohr is the successful author of numerous business basics books, including: Where Did the Money Go? - Accounting Basics for the Business Owner Who Hates Numbers and How Much Should I Charge? - Pricing Basics for Making Money Doing What You Love.

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