What is accrual in GAAP standard accounting?
This post is for small businesses that are vetting new accounting software systems. We hope you find it useful.
There are two accounting methods practiced by companies: the accrual accounting method and the cash accounting method.
Only the accrual accounting method is allowed by generally accepted accounting principles (GAAP).
Accrual Accounting Method
Accrual accounting recognizes costs and expenses when they occur rather than when cash is exchanged. The matching principle of accrual accounting requires that companies match revenue and expenses with the periods in which they are incurred.
The process of accrual applies when a single logical transaction like receiving inventory occurs in two distinct steps separated in time. For example, you will want to accrue any receipt of inventory, acknowledging the increase to the value of your inventory when it comes in the door.
However, typically this happens before you have received the invoice from the vendor for these goods and therefore, (until the invoice is vouchered later by you) you have not acknowledged the liability for this purchase. The accrual process bridges the gap between receipt of the asset and the creation of the offsetting liability by saving the asset value so it can be matched later against this liability.
Professional Level Accounting Software for Small Business
One important practical point to keep in selecting accounting software for small business and midsized companies that supports GAAP standards is that a professional level accounting software system includes the ability to automate and integrate various business functions.
Here is an overview of a sample GAAP-compliant configuration:
The major players in the Purchase Order/Order Entry/Inventory area, from an accounting point of view, are Accounts Receivable (AR), Accounts Payable (AP) and Inventory (IC). The operational level functions like Purchase Orders (PO) and Order Entry (OE) would pass data to AR, AP and IC functions to have them do the actual posting of the accounting transactions. These transactions would include:
• IC – Inventory quantities and rolling inventory costs
• AP – Open Item liabilities (AP) for purchased items
• AR – Revenue entries for AR Open Items from customer invoices
For GAAP compliance, these specific relationships your small business accounting software should include:
A. When a receiving is done through PO Receivings, the data should pass to the IC function to update the quantities and running costs for each of the items received. The Inventory function should create the appropriate GL transactions to be passed into the GL – in this case a debit to inventory costs, and a credit to the “Inventory Suspense”/”Uninvoiced receivings” account. This latter account would be an accrual/suspense account that holds the receiving inventory value pending the later receipt of the vendor invoice for that receiving.
B. When a vendor invoice is received, a voucher is entered into AP that records the cost of the inventory received. The AP function should produce GL transactions that credit the AP Open liability account and debit the accrual/suspense/balance sheet liability account mentioned in section A above. The debit value should reverse the value posted to the accrual account by the Receiving that this voucher is to pay. (To have this happen automatically, each vendor who regularly or primarily supplies inventoried materials could have their individual default expense account changed to be the Uninvoiced Receivings/B/S Liability account.)
C. The net effect of these two inventory receiving and vouchering steps (A and C) would be to increase (debit) inventory assets and to record, i.e., acknowledge in AP, the liability to pay for that inventory (credit AP Open Items). A subsequent step to cut a check would credit Cash and debit AP Open items which would clear the liability.
Order Entry, Billing – Inventory and Accounts Receivable
D. A more complex parallel to the above steps would be played out if an order were entered and then billed.
Note: Only the actual bill posting step in the billing cycle would have a permanent effect on the accounting system, both from the point of view of inventory as well as sales. Generally speaking, entering orders does alter some statistical counters but there is usually no permanent effect made by entering orders, neither for On-Hand quantities or costs nor for sales revenue.
When the invoice was billed and posted, basically, we would have the two sets of transactions that would be repeated for each line item:
• The reduced inventory quantity based on the line item shipped quantity and the COGS as based on average cost and line-item shipped quantity would be computed.
• And, the sales revenue and the line-item shipped quantity would be computed.
These two transaction sets would trigger two distinct sets of operations:
For the costing/inventory side of the transaction, the OE module would pass data to IC – the item quantities and costs that are involved with each line item of the invoice. The result of the sale/shipment would be to decrease the inventory count for that item and to produce distribution transactions that would decrease (credit)the inventory value by the (current/instantaneous) Avg-cost * posted quantity. This cost value would also debit the Cost of Goods Sold account.
This is a key point about the value and timing of the creation of the cost of sales posted to the GL. The term instantaneous is used here deliberately because the average cost can literally be changing minute by minute including just before the billing transaction is posted and/or just after, depending on when receivings are being posted.
For the pricing or sales side of the transaction, OE would hand off data to AR which would perform the steps that update the AR Open Item file (and other history files) and, in turn, AR would generate the GL transactions reflecting the sales, i.e., debit AR Open Items, credit Revenue/Sales.
Accounting Software Streamlines GAAP Standards
Also note that in this example, GAAP standards are followed:
· In receiving inventory, cost would be recognized at Receiving time but liability for that cost would be recognized only when the AP Voucher is posted.
· Because the inventory asset account is a balance sheet account, the inventory asset account value could be carried forward from month to month. Thus, adjustments for Opening Balance and Closing balance each month would not be needed, i.e., this would be a Perpetual Inventory. In addition, the inventory value would be as “real-time” as the interface process that moves these transactions into the GL, i.e., if you interface monthly then it would be correct as of that one time, if you interface weekly then 4 times per month the value would be correct.
· COGS (Cost of Goods Sold) would only be recognized when the Invoice is posted which also means when the product is shipped; and recognition would be simultaneous with the reduction in Inventory asset value. The values used to compute the COGS would be for each line item, using the current instantaneous average cost. So costing and gross profit statistics could be recorded with a granularity down to the individual line item on each invoice.
· Since COGS would be recognized from OE on a line-by-line basis, and the inventory would be reduced in parallel with this COGS calculation, the inventory would be correct with each posted line item.
· Since the inventory value would be increased by Receivings in PO and decreased by shipments through OE invoice posting, the Accounts Payable process would have no effect on inventory asset value and would be asynchronous with respect to timing.
In general, accrual accounting provides for a better sense of a company’s overall financial health than the cash basis accounting method.
That is primarily why it has been adopted as a best practice and integrated into the broad set of rules defined through generally accepted accounting principles (GAAP) and issued through the standards of the Financial Accounting Standards Board (FASB).
This information was sourced from our own Tips and Tricks #27article, GL Distributions from Inventory, Purchase Order and Order Entry by Peter Dalziel, VP Customer Care, and this Investopedia article.