Accrual accounting is considered to be the standard accounting practice for most organizations, and is mandated for organizations of any real size. If Lamichhane were using this method then she would need to include all of her invoiced amounts for the period as ‘sales’ even if she had not actually received payment by the period end. Similarly, if she has a bill with an invoice date within the period she must include it even though she knows that she won’t be paying it until after the period end.
The accrual method recognizes a sale at the point at which the customer takes ownership of the goods or the point when the service is delivered, even though the cash isn’t yet in the bank. Similarly, costs may be recognized before an invoice is received if the organization accepts that the cost has been incurred during the accounting period.
This method provides a more accurate picture of the organization’s current condition, but it is more complex to administer when payments received are less than the amount invoiced. This can happen if the customer disputes the amount or simply refuses to pay. The need for the accrual method arose out of the increasing complexity of an organization’s transactions and a desire for more accurate financial information.
Selling on credit and projects that provide revenue streams over a long period of time affect the organization’s financial circumstances at the point of the transaction. It makes sense that this is reflected on the financial statements during the same reporting period that these transactions occurred.
Before looking at an example of an income statement using the accrual method, there are some financial terms that you need to know. You will also need to appreciate some accounting principles like the ‘revenue recognition principle’ and the ‘matching principle.’
Key Points
- Accrual accounting is considered to be the standard accounting practice for most organizations, and is mandated for organizations of any real size.
- Revenue is recognized once the customer has ownership.
- Costs are incurred in the period in which they arise.
- It provides a more accurate financial picture, but is more difficult to administer.
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