In cost accounting, an effective budget applies the matching principle. The principle says you should match the timing of the expenses of creating and delivering your product or service with the timing of getting revenue from the sale. This is accrual basis accounting.
Accrual accounting ensures that revenue is better matched with the expenses incurred to generate revenue. In simple terms, with accrual accounting you realize or recognize expenses when you incur them, not when you pay them. You realize revenue when you generate it, not when the customer pays.
When you create an invoice, the accounts receivable (A/R) system generates a receivable, even though the customer may not pay for, say, 30 days. When the payment comes in, the receivable goes flat, meaning it’s been satisfied by the payment. Accrual accounting is considered to provide a more accurate reflection of business activity than cash accounting.
By the way, the accrual accounting system still allows for straight cash sales — where you sell now and the customer pays now.
The same is true of purchases you make. When you buy now and pay later, you create a payable. When the bill comes and you pay it, the payable goes flat. Of course, the system allows you to make straight cash purchases — where you buy and pay your vendor now.
Say you manage a catering business. The food, preparation cost, and delivery expenses related to the Jones family reunion should be matched with the revenue from Jones family. Ideally, you want the expense and the revenue to be posted in the same time period. You wouldn’t want the Jones expenses posted in March and the Jones revenue posted when they paid (say, in April). That’s not the best reflection of your business activity.
The downside of accrual accounting is that your income statement revenue and expenses rarely match your cash inflows and outflows. You can be rich in receivables and darned poor in cash. All companies still prepare a cash flow statement even if they are using accrual accounting.
