Accrual Accounting

This is a very important concept, as most financial information is tracked on an accrual basis. (Your accountant can discuss any exceptions to this general rule with you.)

The principle underlying accrual accounting is matching. The matching principle says that income and expenses should be recorded in the period to which they relate, not necessarily the period in which cash actually changes hands. Here are some examples of accrual accounting:

1. A customer buys product from you in January but she does not pay you until March. The conditions for the sale were met in January (Le., she came and picked up the product), so the sale would be recorded in January. Instead of cash, we have generated another asset: accounts receivable.

2. You start your business in September and pay your business insurance premium for the period September 1 to August 31. The insurance cost that relates to September is only one-twelfth of the premium paid, not the whole amount of the payment.

3. You pay your employees every two weeks. You have a December 31 year end and your last paychecks go out on December 26, covering the two-week period ending December 24. There is still seven days worth of salary expense in December not yet paid for (the 25th to the 31st). You would make an adjustment to accrue that salary in the current year, not in the next year, when it will actually be paid out. Instead of a credit to the bank, you have created a liability to pay employees.