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Business accounting systems choose between two different methods for handling the timing of revenues and expenses. Accrual accounting uses a method in which revenues are tied more closely to the expenses incurred that enabled the revenue. The accrual concept allows a more accurate analysis of profitability and supports most large businesses. This type of accounting is very important for businesses whose revenues precede or follow significantly after expenses on which they were earned; businesses whose financial year end lies between the expense and revenue cycles of the business use this method as well.
In the accrual concept, an attempt is made to allocate related revenues and expenses in the same time period. A revenue or expense is said to be “realized” when it is applied to a direct expense or income account rather than an accrual account. A simple example is the allocation of a utility bill that is paid quarterly. Utility bills are not generally associated with a particular revenue source but are expensed against an overhead account that is accounted for monthly. In the accrual concept, one third of the bill would be realized in each month for which utility service was provided in the direct expense account for utilities and the remainder in an accrual account.
In some businesses, deposits are received on future deliverables. A business with accrual accounting would hold the deposit money in an accrual liability account, as the company is now liable for future work. The offsetting journal entry is an increase in cash in an asset cash account. The equity position of the company has not changed. When the work is complete, the deposit amount is no longer a liability and the equity position of the company has increased.
Some business revenue may occur after the end of the fiscal year in which the expenses occurred. A specialized manufacturing company may spend three months preparing for a particular sales event, for example. Expenses may involve labor and materials to create the goods sold at this sales event. If the year end falls at the end of the preparations and before the sales event, expenses will not be tied to subsequent revenue. In the accrual concept, the expense would not be realized until the revenue for it was received.
Moving the date of the fiscal year end solves this problem for many seasonal companies. Project accounting is used to track particular business revenue streams so the accrual concept can allocate specific revenues to specific expenses and more accurately report the profitability of the various business activities. Cash accounting, in which expenses and revenues are realized when incurred or received, is used by small companies to avoid the more cumbersome accrual accounting.