subject: Importance of Accrual Accounting [print this page] Importance of Accrual Accounting Importance of Accrual Accounting
For most smaller companies, cash flow is the most important aspect of accounting. Without the exchange of cash the business would not be able to operate. However, larger company may already have enough cash in overhead to operate so the flow of actual cash may not be as important. Instead the larger companies will focus heavily on accrual accounting. The accrual concept recognizes revenue at the point of sale or expenses when they are incurred. They will recognize these even though the cash receipt or payment may occur at a later time period. Therefore the company will have to recognize two things: first the accrual of the revenue or expense at the time it is complete and then the actual transfer of the cash at a separate time.
The importance of accrual accounting comes into play in financial statements of certain time periods. A company's performance for the year should be based entirely on the work that was performed within the time period and not the actual cash that was transferred. This can be crucial for certain businesses that are currently relying on government stimulus grants. Most of the stimulus grants will require that the work needs to be performed during a certain period and that you have to show exact amounts earned during that time period.
For example, let's say you own an electrical production company that is investing in a small solar energy plant. You awarded a contract to a construction company for $5 million to build the plant that was designed in house. The payment terms of the contract state that you will pay the contractor on a quarterly basis and withhold a retainage amount from each payment until all punch list items from the commissioning reports are complete, which could be several months after the plant is operational. The solar plant that you decided to build falls under the American Recovery and Reinvestment Act. This act allows you to receive 50% of the cost of the plant back in federal grants. In order to get the grants you have to prove the project operational by the end of 2010 and show a complete cost for the project. The payment of the grants is immediate so as the owner of the plant you are looking to receive the money as soon as possible. For some companies, like the one in this example, the grant money is the driving force for building the project. For instance, the time before payback from spending $5 million to build it could be 10 years but with the grant money you shorten it to only 5 years before payback. That means getting the project done in time and showing the costs to build it are very crucial.
Now the contractor ends up finishing the construction on time and the plant is operational at the end of December 2010. However, you have only paid the contractor $3 million dollars so far and the remaining $2 million will not be paid until June of 2011 based on the punch list items that need to be complete and payment terms. This is where accrual accounting becomes important. Your company will need to do an accrual report that shows the total cost of the actual work completed on the project even though the complete amount is yet to be paid. Therefore, with accruals you are able to receive the $2.5 million in grant money before the total $5 million of the project was paid out to the contractor. This would keep your rate of return to 5 years and make the project a success.
