Definition: The accrual basis of accounting is a system of recognizing revenues and expenses when they are incurred instead of focusing on when they are paid or collected. This means that both revenues and expenses are recognized and recorded in the accounting period when they occur instead of when payments are actually made. GAAP requires businesses to use the accrual method because it more accurately reflects the financial position of a company than the cash basis.
What Does Accrual Basis Mean?
What is the definition of accrual basis? This accounting method ignores when cash payments were actually sent or received. Instead, it is more concerned with the economic status of a transaction by focusing on when the revenues were earned and when the payments were owed. Under the accrual basis, income is only recognized and recorded when it is earned. Companies technically earn income when a service is provided or a product is delivered. Likewise, expenses are only recorded when incurred. Businesses incur expenses when they receive a service or product.
Let’s take a look at an example.
Example
Pike’s Fish Co. is a retailer that sells outdoor gear like fishing polls and tackle to customers. Pike is working with a large customer, Mike, on a big order in December. Mike wants to purchase $10,000 worth of outdoor supplies to fill his new skiing lodge up north. Since the customer hasn’t fully decided what specific products he wants to purchase, he decides to put a down payment of $5,000 on his order to make sure Pike holds the gear that he knows he does want.
As the end of the year approaches, Mike is still uncertain about finalizing his order. According to the accrual method of accounting, Pike cannot record this as a sale in the current year because he didn’t earn it. No goods or services were exchanged. Mike simply put a down payment on an unfinished ordered.
When Pike receives the $5,000, he would debit cash and credit the unearned revenue liability account. No revenues from this transaction would be reported on the income statement for this year.
Summary Definition
Define Accrual Basis: The accrual basis means a way of recording income and expenses based on the period they are incurred rather than the period they are collected or paid.
