What Does Amortization MeanA major part of the mortgage process involves looking at purchase price, interest rates and down payment amount. Together they help determine the mortgage, or loan, amount and how it will be financed, which is translated into a schedule known as amortization.Basic Definition

Amortizing a debt means to reduce the balance by paying principal and interest on an established schedule. By making regular, scheduled payments on time, the loan or mortgage will be paid off by a maturity date.Fixed-Rate Mortgages

By making regular payments toward a mortgage, you reduce the balance of both principal and interest. A fixed-rate mortgage fully amortizes at the end of the term. In the case of a 15-year fixed-rate mortgage, the loan is paid in full at the end of 15 years. A 30-year fixed-rate mortgage is paid in full at the end of 30 years, if payments are made on schedule. Loans with shorter terms have less interest because they amortize over a shorter period of time.Adjustable-Rate Mortgages

Adjustable-rate mortgages (ARMs) also fully amortize, regardless of the fluctuating interest rate. For example, a 15-year ARM will still be paid in full at the end of the 15-year term if payments have been made regularly, despite interest rates that may have risen and fallen during the life of the loan.Calculating Amortization

You can calculate a mortgage amortization schedule if you know a couple of key pieces of information: periodic interest rate and loan balance. Beginning with the first month, multiply the mortgage balanceby the periodic interest rate. This will give you the first month's interest payment. Subtract that interest payment from the total payment to learn the principal amount. To figure the principal and interest payments for subsequent months, subtract the first month's payment from the mortgage balance, then repeat.

Interest First

In the earlier part of the amortization schedule, monthly payments arecomposed primarily of interest. As the schedule continues, more principal is paid from each monthly payment. A detailed amortization schedule from your lender will provide exact amounts of how much of each monthly payment goes toward interest and toward principal

Definition:In the lending, amortization is the process of paying off a loan. The loan balance gradually decreases as you make interest and principal payments on the loan.

Loan Amortization CalculatorA Loan Amortization Calculator For Any Purpose

The loan amortization calculator is intended to show you how your loan will work month-by-month, including information about:

Your monthly payment How much of your loan gets paid off each month How much of your monthly payment goes to interest each month How much you'll owe on your loan at any point in timeThe loan amortization calculator includes an amortization table for your reference.

Site- http://banking.about.com/od/loans/g/amortization.htm

DEFINITION OF 'AMORTIZED LOAN'A loan with scheduled periodic payments of both principaland interest. This is opposed to loans with interest-onlypayment features, balloon payment features and even negatively amortizing payment features.

INVESTOPEDIA EXPLAINS 'AMORTIZED LOAN'Borrowers who choose amortized loans are less likely to experience "payment shock" than borrowers who choose loans which are not fully amortized. Payments on loans that are not initially fully amortized must at some pointbecome amortized over the remaining term of the loan in order to repay the outstanding principal balance. The shorter the remaining term, the larger the increase required in the periodic payments to amortize the loan over the remaining term

What does it mean to amortize a loan?To amortize a loan usually means establishing a series of equal monthly payments that will provide the lender with 1) interest basedon each month's unpaid principal balance, and 2) principal repayments that will cause the unpaid principal balance to be zeroat the end of the loan. While the amount of each monthly payment is identical, the interest component of each payment will be decreasing and the principal component of each payment will be increasing during the life of the loan.

To illustrate, let's assume a lender proposes to amortize a

$60,000 loan at 4% annual interest over a 3-year period. This will require 36 monthly payments of $1,771.44 each. The first payment will consist of an interest payment of $200.00 ($60,000 X4% X 1/12) plus a principal payment of $1,571.44 ($1,771.44 - $200.00). After the first payment is made, the principal balance will be $58,428.56 ($60,000.00 - $1,571.44). The second monthly payment of $1,771.44 will consist of interest of $194.76 ($58,428.56 X 4% X 1/12) plus a principal payment of $1,576.68 ($1,771.44 - $194.76). After the second payment is made, the remaining (or unpaid) principal balance will be $56,851.88.

The 36th and final monthly payment of $1,771.44 will consist of interest of $5.89 (the principal balance after the 35th payment, which will be $1,765.55, times 4% X 1/12) plus a principal payment of $1,765.55. After the 36th payment the loan balance will be zero. In other words, the loan will have been amortized over its 3-year term.

A listing of each month's interest and principal payments (and the remaining, unpaid principal balance after each payment) is referred to as an amortization schedule.

loan amortizationSave to Favorites

DefinitionThe gradual repayment of a debt over a specific period of time. Payments are usually due on a recurring and cyclical basis (e.g., monthly), and include interest on top of principal.

amortized loan  

Definition Add to Flashcards Save to Favorites See Examples

Installment loan in which the monthly payments are applied first toward reducing the interest balance, and any remaining sum towards the principal balance. As the loan is paid off, a progressively largerportion of the payments goes toward principal and a progressively smaller portion towards the interest. Also called amortizingloan.

Amortizing loanFrom Wikipedia, the free encyclopedia

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This article needs additional citations for verification. Please help improve this article by adding citations to reliable sources.Unsourced material may be challenged and removed. (March 2007)

In banking and finance, an amortizing loan is a loan where the principal of the loan is paid down over the life of the loan (that is, amortized) according to an amortization schedule, typically through equal payments.

Similarly, an amortizing bond is a bond that repays part of the principal (face value) along with the coupon payments. Compare with a sinking fund, which amortizes the total debt outstanding by repurchasing somebonds.

Each payment to the lender will consist of a portion of interest and a portion of principal. Mortgage loans are typically amortizing loans. The calculations for an amortizing loan are those of an annuity using the time value of money formulas, and can be done using an amortization calculator.

An amortizing loan should be contrasted with a bullet loan, where a large portion of the loan will be paid at the final maturity date instead of being paid down gradually over the loan's life.

An accumulated amortization loan represents the amount ofamortization expense that has been claimed since the acquisition of the asset.

Contents

1   Effects 2   Weighted-average life 3   See also 4   References

Effects[edit]

Amortization of debt has two major effects:

Credit risk

First and most importantly, it substantially reduces the credit risk of the loan or bond. In a bullet loan (or bullet bond), the bulk of the credit risk isin the repayment of the principal at maturity, at which point the debt must either be paid off in full or rolled over. By paying off the principal over time, this risk is mitigated.

Interest rate risk

A secondary effect is that amortization reduces the duration of the debt, reducing the debt's sensitivity to interest rate risk, as compared to debt with the same maturity and coupon rate. This is because there are smaller payments in the future, so the weighted-average maturity of the cash flows is lower.

Weighted-average life[edit]Main article: Weighted-average life

The number weighted average of the times of the principalrepayments of an amortizing loan is referred to as the weighted-average life (WAL), also called "average life". It's the average time until a dollar of principal is repaid.

In a formula,

where:

 is the principal,  is the principal repayment in coupon  , hence

 is the fraction of the principal repaid in coupon  , and

 is the time from the start to coupon  .

What does it mean to amortize a loan?To amortize a loan usually means establishing a series of equal monthly payments that will provide the lender with 1) interest basedon each month's unpaid principal balance, and 2) principal repayments that will cause the unpaid principal balance to be zeroat the end of the loan. While the amount of each monthly payment is identical, the interest component of each payment will be decreasing and the principal component of each payment will be increasing during the life of the loan.

To illustrate, let's assume a lender proposes to amortize a $60,000 loan at 4% annual interest over a 3-year period. This will require 36 monthly payments of $1,771.44 each. The first payment will consist of an interest payment of $200.00 ($60,000 X4% X 1/12) plus a principal payment of $1,571.44 ($1,771.44 - $200.00). After the first payment is made, the principal balance will be $58,428.56 ($60,000.00 - $1,571.44). The second monthly payment of $1,771.44 will consist of interest of $194.76 ($58,428.56 X 4% X 1/12) plus a principal payment of $1,576.68 ($1,771.44 - $194.76). After the second payment is made, the remaining (or unpaid) principal balance will be $56,851.88.

The 36th and final monthly payment of $1,771.44 will consist of interest of $5.89 (the principal balance after the 35th payment, which will be $1,765.55, times 4% X 1/12) plus a principal payment of $1,765.55. After the 36th payment the loan balance will be zero. In other words, the loan will have been amortized over its 3-year term.

A listing of each month's interest and principal payments (and

the remaining, unpaid principal balance after each payment) is referred to as an amortization schedule.

Adjusting Entries for Prepaid ExpenseinShare

Prepaid expenses (a.k.a. prepayments) represent payments made for expenses which are not yet incurred.

In other words, these are "advance payments" by a company for supplies, rent, utilities and others that are still to be consumed.Expenses are recognized when they are incurred regardless of when paid. Expenses are considered incurred when they are used, consumed, utilized or has expired.Because prepayments they are not yet incurred, they are not recorded as expenses. Rather, they are classified as current assets.Prepaid expenses may need to be adjusted at the end of the accounting period. The adjusting entry for prepaid expense depends upon the journal entry made when it was initially recorded.There are two ways of recording prepayments: (1) the asset method, and (2) theexpense method.Asset MethodUnder the asset method, a prepaid expense account (an asset account) is recorded when the amount is paid. Prepaid expense accounts include: Office Supplies, Prepaid Rent, Prepaid Insurance, and others.In one of our previous illustrations (if you have been following our comprehensive illustration for Gray Network Services), we made this entry to record the purchase of service supplies:

Dec 7 Service Supplies 1,500.00  

    Cash   1,500.0

0

Take note that the amount has not yet been incurred, thus it is proper to record it as an asset.Suppose at the end of the month, 60% of the supplies have been used. Thus, outof the $1,500, $900 worth of supplies have been used and $600 remain unused. The $900 must then be recognized as expense since it has already been used.

In preparing the adjusting entry, our goal is to transfer the used part from the asset initially recorded into expense -- for us to arrive at the proper balances shown in the illustration above.The adjusting entry will include: (1) recognition of expense and (2) decrease in the asset initially recorded (since some of it has already been used). The adjusting entry would be:

Dec 31

Service Supplies Expense 900.00  

    Service Supplies   900.00

The "Service Supplies Expense" is an expense account while "Service Supplies" is an asset. After making the entry, the balance of the unused Service Supplies is now at $600 ($1,500 debit and $900 credit). Service Supplies Expense now has a balance of $900. Now, we've achieved our goal.Expense MethodUnder the expense method, the accountant initially records the entire payment as expense. If the expense method was used, the entry would have been:

Dec 7 Service Supplies Expense

1,500.00  

    Cash   1,500.00

Take note that the entire amount was initially expensed. If 60% was used, thenthe adjusting entry at the end of the month would be:

Dec 31 Service Supplies 600.00  

    Service Supplies Expense   600.00

This time we are making a debit to Service Supplies for $600 (the unused portion). Service Supplies Expense is credited thus decreasing its balance. Service Supplies Expense is now at $900 ($1,500 debit and $600 credit).Notice that the resulting balances of the accounts under the two methods (asset and expense) are the same (Cash paid: $1,500; Service Supplies Expense:$900; and Service Supplies: $600).Another ExampleGVG Company acquired a six-month insurance coverage for its properties on September 1, 2013 for a total of $6,000.Under the asset method, the initial entry would be:

Sep 1 Prepaid Insurance 6,000.00  

    Cash   6,000.00

On December 31, 2013, the end of the accounting period, part of the prepaid insurance already has expired (hence, expense is incurred). The expired part is the insurance from September to December. Thus, we should make the following adjusting entry:

Dec 31 Insurance Expense 4,000.0

0  

    Prepaid Insurance   4,000.00

Of the total six-month insurance amounting to $6,000 (or $1,000 per month), the insurance for 4 months has already expired. In the entry above, we are actually transferring $4,000 from the asset to the expense account (i.e., fromPrepaid Insurance to Insurance Expense).

If the company made use of the expense method, the initial entry would be:

Sep 1 Insurance Expense 6,000.00  

    Cash   6,000.00

In this case, we must decrease Insurance Expense by $2,000 because that part has not yet been incurred (not used/not expired). Insurance Expense shall thenhave a balance of $4,000. The amount removed from the expense shall be transferred to Prepaid Insurance. The adjusting entry would be:

Dec 31 Prepaid Insurance 2,000.0

0  

    Insurance Expense   2,000.00

ConclusionWhat we are actually doing here is making sure that the incurred (used/expired) portion is included in expense and the unused part into asset. The adjusting entry will always depend upon the method used when the initial entry was made.If you are having a hard time understanding this topic, I suggest you go over and study the lesson again. Sometimes, it really takes a while to get the concept. Preparing adjusting entries is one of the challenging (but important)topics for beginners.Online resource for all things accounting. more   ›

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Two ways of accounting for prepaidexpenses

2.1. Balance sheet approach

We will further assume that the company does not adjust the prepaid insurance balance until the end of the fiscal year (December 31, 20X0).

At the end of the calendar (fiscal) year – December 31, 20X0 – the company will have $8,000 (4 months x $2,000 monthly expense) left as unused prepaid insurance expense. Considering this, the company will need to adjust its prepaid insurance balance of $24,000 to make it $8,000, and the difference ($16,000) will be recorded as insurance expense for the year.

The following journal entries will be recorded by the company:

a) To record the premium payment on April 15, 20X0:Account Titles Debit CreditPrepaid Insurance

24,000  

      Cash   24,000

b) To record insurance expense for year 20X0 (8 months) on December 31, 20X0:Account Titles Debit Credi

tInsurance Expense 16,000        Prepaid Insurance

  16,000

As you can see, the company applied the balance sheet approach to account for its prepaid insurance. In particular, the company calculated what balance of prepaid insurance should remain on the balance sheet and made the necessary adjustment.2.2. Income statement approach

The company could also have applied another way of accounting for prepaid insurance. Assume the same scenario as before. However, this time the company recorded the entire amount of prepaid insurance of $24,000 as insurance expense in the income statement at the time of the premium payment. At the endof the year, the company calculated what the insurance expense for 20X0 shouldhave been. The insurance expense was determined as follows: 8 months x $2,000 = $16,000. The company then adjusted the insurance expense by moving the difference ($8,000) from the income statement to the balance sheet.

The following journal entries would have been recorded by the company:

a) To record premium payment on April 15, 20X0:Account Titles Debit Credi

tInsurance Expense 24,000        Cash   24,00

0

b) To record prepaid insurance balance at the end of year 20X0 (4 months remaining):Account Titles Debit CreditPrepaid Insurance 8,000        Insurance Expense

  8,000

This is the income statement approach because the company initially recorded the entire insurance premium as insurance expense and then adjusted the

expense (by allocating a portion of it to the balance sheet) at the end of theyear.2.3. Comparison of two methods of accounting for prepaid expense

Let us now go back to the two scenarios and compare results:  Balance Sheet

ApproachIncome Statement

ApproachPrepaidInsurance

InsuranceExpense

PrepaidInsurance

InsuranceExpense

April 15, 20X0:Premium Payment

$24,000 $0 $0 $24,000

December 31, 20X0:Year-end Adjustment

($16,000) $16,000 $8,000 ($8,000)

December 31, 20X0:Ending Balance

$8,000 $16,000 $8,000 $16,000

As you can see, no matter which approach is selected, the ending balances in the prepaid insurance (balance sheet) and the insurance expense (income statement) will be the same.

Prepaid Expense

Definition: Prepaid expense is an expenditure that is paid for in one accounting period, but for which the underlying asset will not be entirely consumed until a future period. An example of a prepaid expense is insurance, which is frequently paid in advance for multiple future periods; an entity initially records this expenditure as a prepaid expense, and then charges it to expense over the usage period.

A prepaid expense is listed within the current assets section of the balance sheetuntil the prepaid item is consumed. Once consumption has occurred, the prepaid expense is removed from the balance sheet and is instead reported in that period as an expense on the income statement. If the total ending balance in the prepaid

expenses account is quite small, it may be aggregated with other assets and reported within an "other expenses" line item in the balance sheet.

What are prepaid expenses?Prepaid expenses are future expenses that have been paid in advance. You can think of prepaid expenses as costs that have been paid but have not yet been used up or have not yet expired.

The amount of prepaid expenses that have not yet expired are reported on a company's balance sheet as an asset. As the amount expires, the asset is reduced and an expense is recorded for the amount of the reduction. Hence, the balance sheet reports the unexpired costs and the income statement reports the expired costs. The amount reported on the income statement should be the amount that pertains to the time interval shown in the statement's heading.

A common prepaid expense is the six-month premium for insurance on a company's vehicles. Since the insurance company requires payment in advance, the amount paid is often recorded in the current asset account Prepaid Insurance. If the company issues monthly financial statements, its income statement will report Insurance Expense that is one-sixth of the amount paid. The balance in the account Prepaid Insurance will be reduced by the amount that was debited to Insurance Expense.

1. Small Business   >2. Accounting & Bookkeeping   >3. Business Expenses

What Are Prepaid Expenses/Prepaid Revenues & How Are They Reported on the Balance Sheet?by Jay Way, Demand Media

Prepaid expenses and prepaid revenues are prepayments by businesses and customers. These aren't actual expenses and revenues, but assets and liabilities recorded on the balance sheet at the time of the prepayments. As abusiness incurs expense and realizes revenue from the prepayments in the future, it deducts portions of the prepaid expenses and prepaid revenues as the current expense and revenue. Therefore, prepaid expenses and prepaid revenues over time experience a decrease in their outstanding balances as reported on the balance sheet.

Prepaid ExpensesPrepaid expenses are future expenses that a business pays for in advance before it actually incurs them, such as insurance coverage for next year or rent paid for next month. Before prepaid expenses are consumed, businesses consider them assets that can provide future benefits. Prepaid expenses expireeither with the passage of time or through use and consumption. In other words, prepaid expenses as assets are gradually used up as a business incurs the related expenses over time.

Report Prepaid ExpensesBusinesses report prepaid expenses as assets on the balance sheet. At the timewhen a business makes prepayments for future expenses, it debits the asset account of prepaid expenses to increase the account balance, and credits the cash account to record the cash payments. At the end of an accounting period, the business makes an adjusting entry to the account of prepaid expenses basedon the amount of expense actually incurred. Thus, a debit is made to an expense account to record the expense incurred, and a credit to the account ofprepaid expenses to reduce its outstanding balance as assets.

Related Reading: Does a Change in Net Working Capital Include Prepaid Expenses?Prepaid RevenuesPrepaid revenues, also referred to as unearned revenues, are prepayments that a business receives from its customers for future delivery of goods or services. Following the revenue recognition principle, businesses cannot record customer prepayments as recognized revenues until sales to customers are completed. Examples of prepaid revenues include airline ticket sales before flight services or school tuition received during registration. Holding

customer payments, a business is liable for the future transfer of goods or serves. Thus, prepaid revenues are liabilities for businesses, and become earned revenues over time as they complete the intended sales.

Prepaid ExpensePrepaid expense is expense paid in advance but which has not yet been incurred.Expense must be recorded in the accounting period in which it is incurred. Therefore, prepaid expense must be not be shown as expense in the accounting period in which it is paid but instead it must be presented as such in the subsequent accounting periods in which the services in respect of the prepaid expense have been performed.Entity should therefore recognize an asset in respect of expense it has paid in advance until such time as the services that are due in relation to the prepaid expense have been performed by the suppliers/contractors. Following accounting entry is required to account for the prepaid expense:

Debit Prepaid Expense (Asset)

Credit Cash

ExampleABC LTD pays advance rent to its landowner of $10,000 on 31st December 2010 inrespect of office rent for the following year. ABC LTD has an accounting year end of 31st December 2010.ABC LTD will recognize an asset of $10,000 in the financial statements of year2010 in respect of the prepaid expense to recognize its right to use office space in the following year. Following accounting entry will be recorded in the books of ABC LTD in the year 2010:

$ $

Debit Prepaid Rent

10,000

Credit Cash 10,00

0

The prepaid expense will be recognized as expense in the next accounting period to which the rental expense relates. Following accounting entry will berecorded in the year 2011:

$ $

Debit Rent Expense (Income Statement)

10,000

Credit Prepaid Rent 10,00

0

- See more at: http://accounting-simplified.com/prepaid-expense.html#sthash.XVTgY5mt.dpuf

Preliminary expeneses arethe nature of fictitious assets. These are the formation expenses of the company before any operation of the busines held. These are transferred to the profit and loss accounts and written off every year from the profits of the business. These expenses are shown on the assets of the balance sheet under the head misceallenous. 

Is This Answer Correct ?   

521 Yes 51 No

Jagadeesh.Rt

 

Answer# 2

Expenses incurredbefore the commencement of the business are prelimary expenses and samewill be deferred over the period will be shown under Assets side of balance sheet as Miscellaneous Expenses (Asset). 

Is This AnswerCorrect ?   

210Yes

23 No

Jagannath C V

 

 

Answer# 3

Preliminary Expenses is the expenses incurredbefore the commencement of the company that beared by the promoters of the company for its incorporation. Asit is considered

SudhiSharma

as one of the fictitious asset of the company and is treated as deffered revenue expenditure because it derives benefits in the long run and thus written off every year onthe asset side of thebalance sheet 

Is This AnswerCorrect ?   

102Yes

19 No

 

Answer# 4

Preliminary expenses which wepaid incorporate the company. that expenses shall be transfered to profit & loss a/c.for some years.so it will be in current asset. 

Is 227 156

Rajesh

This AnswerCorrect ?   

Yes No

 

Answer# 5

All expenses incurred before incorporation of the business is called preliminary expenses.It is show in the assets side of the balance sheet under the miscellaneous expenses. 

Is This AnswerCorrect ?   

75 Yes

20 No

Raj

 

Answer# 6

Expenses incurredprior to the incorporation of a company are called preliminary expenses. They are ficticious assets appearing

on the ASSETS side of the Balance Sheet. Every year a protion of them are written off from the profit and in theBalance Sheet thetotal amount of preliminary expenses is reduced by the amount of expenses written off. 

accrual basis accountingSee Examples   Save to Favorites

DefinitionThe most commonly used accounting method, which reports income when earned and expenses when incurred, as opposed to cash basis accounting, which reports income when received and expenses when paid.Under the accrual method, companies do have some discretion as to whenincome and expenses are recognized, but there are rules governing the recognition. In addition, companies are required to make prudent estimates against revenues that are recorded but may not be received, called a bad debt expense.

praveen  Feb 15th, 2007

 

Hi all,In Report if we use sort it will disply only either asending ordar ordecending order.where as in Filter, it is an condition that limits the amount of data that can displyed in the report.Those records that satisfy the condition only are displyed in the record.Cheers,Praveen

Accrual Accounting

Definition: Accounting method that records revenues and expenses when they are incurred, regardless of when cash is exchanged. The term"accrual" refers to any individual entry recording revenue or expense in the absence of a cash transaction

13

114

Most businesses typically use one of two basic accounting methods in their bookkeeping systems: cash basis or accrual basis. While most businesses use the accrual basis, the most appropriate method for your company depends on your sales volume, whether or not you sell on credit and your business structure.

The cash method is the most simple in that the books are kept based on the actual flow of cash in and out of the business. Income is recorded when it's received, and expenses are reported when they're actually paid. The cash method is used by many sole proprietors and businesses with no inventory.

From a tax standpoint, it is sometimes advantageous for a new business to use the cash method of accounting. That way, recording income can be put off until the next tax year, whileexpenses are counted right away.

With the accrual method, income and expenses are recorded as they occur, regardless of whether or not cash has actually changed hands. An excellent example is a sale on credit. The sale is entered into the books when the invoice is generated rather than when the cash is collected. Likewise, an expense occurs when materials are ordered or when a workday has been logged in by an employee, not when the check is actually written. The downside of this method is that you pay income taxes on revenue before you've actually received it.

Should you use the cash or accrual method in your business? The accrual method is required if your business's annual salesexceed $5 million and your venture is structured as a corporation. In addition, businesses with inventory must also use the accrual method. It's also highly recommended for any business that sells on credit, as it more accurately matches income and expenses during a given time period.

The cash method may be appropriate for a small, cash-based business or a small service company. You should consult your accountant when deciding on an accounting method.

Accrual Accounting

Definition: Accounting method that records revenues and expenses when they are incurred,

regardless of when cash is exchanged. The term"accrual" refers to any individual entry recording revenue or expense in the absence of a cash transaction

13

114

Most businesses typically use one of two basic accounting methods in their bookkeeping systems: cash basis or accrual basis. While most businesses use the accrual basis, the most appropriate method for your company depends on your sales volume, whether or not you sell on credit and your business structure.

The cash method is the most simple in that the books are kept based on the actual flow of cash in and out of the business. Income is recorded when it's received, and expenses are reported when they're actually paid. The cash method is used by many sole proprietors and businesses with no inventory. From a tax standpoint, it is sometimes advantageous for a new business to use the cash method of accounting. That way, recording income can be put off until the next tax year, whileexpenses are counted right away.

With the accrual method, income and expenses are recorded as they occur, regardless of whether or not cash has actually changed hands. An excellent example is a sale on credit. The sale is entered into the books when the invoice is generated rather than when the cash is collected. Likewise, an expense occurs when materials are ordered or when a workday has been logged in by an employee, not when the check is actually written. The downside of this method is that you pay income taxes on revenue before you've actually received it.

Should you use the cash or accrual method in your business? The accrual method is required if your business's annual salesexceed $5 million and your venture is structured as a

corporation. In addition, businesses with inventory must also use the accrual method. It's also highly recommended for any business that sells on credit, as it more accurately matches income and expenses during a given time period.

The cash method may be appropriate for a small, cash-based business or a small service company. You should consult your accountant when deciding on an accounting method.

accrual basis of accountingThe accounting method under which revenues are recognized on the income statement when they are earned (rather than when the cash is received). The balance sheet is also affected at the time of the revenues by either an increase in Cash (if the service or sale was forcash), an increase in Accounts Receivable (if the service was performed on credit), or a decrease in Unearned Revenues (if the service was performed after the customer had paid in advance for the service).

Under the accrual basis of accounting, expenses are matched with revenues on the income statement when the expenses expire or title hastransferred to the buyer, rather than at the time when expenses are paid. The balance sheet is also affected at the time of the expense bya decrease in Cash (if the expense was paid at the time the expense was incurred), an increase in Accounts Payable (if the expense will bepaid in the future), or a decrease in Prepaid Expenses (if the expensewas paid in advance).

Accrual AccountingAAA | 

DEFINITION OF 'ACCRUAL ACCOUNTING'An accounting method that measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur. The general idea is that economic events are recognized by matchingrevenues to expenses (the matching principle) at the time in which the transaction occurs rather than whenpayment is made (or received). This method allows the current cash inflows/outflows to be combined with future expected cash inflows/outflows to give a more accurate picture of a company's current financial condition.

INVESTOPEDIA EXPLAINS 'ACCRUAL ACCOUNTING'Accrual accounting is considered to be the standard accounting practice for most companies, with the exception of very small operations. This method provides a more accurate picture of the company's current condition, but its relative complexity makes it more expensive to implement. This is the opposite of cash accounting, which recognizes transactions only when thereis an exchange of cash.