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Using Accrual Accounting to Make Financial Statements More Useful

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  • 0:01 Goal of Financial Statements
  • 0:42 What Is the Accrual Method?
  • 1:36 The Financial Statements
  • 2:21 How Do They Relate?
  • 4:14 Lesson Summary
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Lesson Transcript
Instructor: Rebekiah Hill

Rebekiah has taught college accounting and has a master's in both management and business.

What is the relationship between the financial statements and accrual accounting? Do you know? By the time this lesson is over, you will not only know what the relationship is between the two but also why that relationship is important.

Goal of Financial Statements

Have you ever set a goal? I do all the time. Some goals are small, and you can achieve them all on your own. But other times, those goals are pretty big, and you need a little bit of help in achieving them. That's kind of like the relationship between accrual accounting and the financial statements.

The goal of the financial statements is to provide financial data that is so accurate and concise that it can paint a vivid picture of how well a company is performing at a specific point in time. Now that's a heavy load to bear for four little reports. But that's where accrual accounting comes in and lends a helping hand. Together, these two important concepts can reach the goal set by the financial statements.

What Is the Accrual Method?

Accrual basis accounting is the form of accounting that records revenue when it is earned and expenses when they are incurred regardless of when cash is received or paid out. Now notice the part of the definition that says 'regardless of when cash is received or paid out.' That's a very important part of this whole idea. It relates to a concept called the revenue recognition principle. The revenue recognition principle states that revenue is recognized, or reported, when it is earned regardless of how cash flows.

The revenue recognition principle goes hand-in-hand with the matching principle. The matching principle states that any costs associated with doing business should be recorded in the same period as the revenue that those costs help generate. Both of these principles are part of GAAP, or Generally Accepted Accounting Principles, which are the guidelines by which accounting is practiced in the United States.

The Financial Statements

Now when we talk about the financial statements, we're talking about the four major reports that companies produce and current and potential investors and creditors are interested in. The first report is the income statement. The income statement tells how much money a company made or lost in a given time period. The statement of retained earnings, which is the second report created, tells how much, if any, of the money that a company makes in an accounting period is retained and reinvested in the company.

The third report, known as the balance sheet, is the report that lists all the accounts that a company has and their balances. The statement of cash flows is the last report that is created for the financial statements. This report lists the cash inflows and outflows of a company.

How Do They Relate?

Now that you know what the accrual method of accounting is and what the financial statements are, just how do the two relate? The answer to that is really rather simple. When someone looks at the financial statements, they want to know that the figures that they see are bottom line figures.

Accrual basis accounting gives them just what they want since it recognizes revenue when it is earned and expenses when they are incurred rather than waiting for cash to change hands or bills to be paid. It paints the true picture of a company's finances and allows financial statement users to know that everything related to the specific time frame listed on the financial statement is accounted for. Let's look at an example to help you better understand the concept.

Leslie and Patty are both small business owners who own print shops. Leslie uses the accrual basis of accounting in her business while Patty uses the cash basis accounting method in hers. They both have just filled orders for personalized invitations that customers wanted and have shipped not only the invitations, but also the $1,000 bill to the customers. Payment is due from the customers within 30 days. So, how will this transaction be recorded in their books?

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