Accrual accounting is a financial accounting method that records revenue when earned and expenses when incurred, regardless of when payment is received or made.
Accrual accounting provides a clearer view of your company’s financial position, enabling better decision-making. In contrast, cash accounting records revenue and expenses only when payment occurs, offering less financial clarity.
In this post, we’ll cover everything you need to know about the accrual method of accounting, including its benefits, types, challenges, examples, a comparison with cash accounting, and how to determine if it’s right for your business.
What Is Accrual Accounting?
Accrual accounting is a financial accounting method in which a company records its revenue and expenses as they are earned or incurred, regardless of whether it receives or makes the payment. This differs from cash accounting, which records revenue or expenses only after receiving/paying the money in exchange for goods/services.
Big businesses widely use it to comply with standard accounting terms and principles like Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).
How Does Accrual Accounting Work?
Accrual accounting works on the principle that revenues and expenses are to be recorded in the company’s financial journal when a transaction happens, irrespective of whether the cash is actually received or paid.
This means if you sell a good or service, you will record this transaction as revenue even if you don’t receive the cash payment at the moment. Similarly, if you purchase any good/service or have any payments and debts due, you will record this transaction as an expense even if you haven’t paid it yet.
Accrual accounting allows you to get a better, more accurate view of your organization’s finances at present and in the long run by combining cash inflows/outflows. This method of accounting also ensures that a company recognizes its expenses and revenues in the same period. It follows the double-entry accounting method for recording revenues and expenses.
What Are the Benefits of Accrual Accounting?
The benefits of accrual accounting for businesses include:
- Accurate financial picture: Since accrual accounting lets you combine all your current and future incoming/outgoing cash flows, you’ll get your company’s full and accurate picture. This way, businesses can effectively manage their resources at present while devising strategies for the future.
- Decision making: Accrual accounting lets you calculate profits and losses accurately by recording revenues and expenses in the same period, especially in long-term projects. As a result, you can use data to make informed and better financial decisions for strategic planning, business expansion, investments, and budgeting.
- Financial Reporting: Accrual accounting showcases the actual transactions, expenses, and revenues that occurred in an accounting period, going beyond just cash flow statements that provide only half the truth. This allows organizations to perform financial reporting more accurately.
- Compliance with accounting standards: Accounting standards, such as GAAP and IFRS, encourage businesses to adopt accrual accounting, which provides a complete view of financial activities. By adopting this method, businesses can more easily comply with these standards, reducing the risks of non-compliance and potential reputation damage.
- Cash flow management: With accrual accounting, you fully understand the cash flow coming in and going out of your business systems. This means you know how much revenue was earned and expenses were incurred in a month or financial period. You can use these insights to manage your cash flow better and make profitable investment strategies.
- Budgeting and forecasting: By matching your expenses to revenues in an accounting period, you can find areas that are under or over budget. This will help you create better budgeting plans and allocate resources strategically. In addition, you can compare your financial statements (prepared according to accrual-based accounting) from different accounting periods to track patterns and make more accurate financial forecasts. This way, you can improve your present and future financial outcomes.
- Stakeholder Confidence: Accrual accounting helps build stakeholders’ (like lenders, investors, partners, etc.) confidence by offering a highly precise and clear view of your organization’s financial activities and health. It could give your business’s finances a stable look by providing consistent metrics that stakeholders can trust, encouraging them to support your businesses and keep investing in them.
- Long-Term Financial Health: Accrual accounting supports your financial health in the long term by matching your revenues and expenses and reflecting true profitability. It ensures your expenses and revenues are aligned with your business’s long-term goals and contracts.
What Are the Principles of Accrual Accounting?
The principles of accrual accounting are the frameworks that guide how a company should record its financial transactions, i.e., revenues and expenses. These principles also ensure that financial reporting is accurate.
Revenue Recognition Principle
In the revenue recognition principle, organizations recognize revenue when it’s actually earned or at the time of delivering products/services to customers.
You’ll need to record the transaction in its financial statements even if you haven’t received the payment for the products/services yet. In this case, companies create an entry – accounts receivable – to track how much amount they are likely to receive from the sales.
Matching Principle
In the matching principle, an organization recognizes the expenses incurred and revenues generated both in the same financial period. This means the accounting principle “matches” a company’s expenses to its revenue, recording the same in the financial statements and reflecting the true profits, losses, income statements, and costs of running the business.
Apart from the above, accrual accounting also uses other principles:
- Full disclosure principle: An organization using the accrual accounting method must “fully disclose” all its relevant financial data in the financial statements to provide a full picture of the organization’s financial status.
- Consistency principle: An organization must use the same accounting principles and methods consistently throughout different accounting periods to maintain consistent financial reporting and help stakeholders make informed business decisions.
Types of Accruals
Accruals are the revenues to be received or earned and expenses to be paid or incurred. If you follow accrual accounting, the types of accruals you can record in your financial statements include:
1. Deferred Revenue
Deferred revenue is the accrual or revenue that a company has yet to earn but the customer has paid for the good/service in advance.
This means the company has received the payment before delivering the goods/services, so the revenue is considered unearned and a liability. In this case, the company creates a deferred revenue account, which runs until it completes the good/service delivery. After this, the revenue will be considered as earned.
Example: A customer buys a service subscription for a year at $60 or $5 per month. This means the service provider has received advanced payment and is yet to provide the service for the entire month. At this point, the revenue of $60 is unearned.
The company will create a deferred account for $60 and reduce $5 per month to reflect service delivery each month for 12 months. At the same time, it will also record $5 in revenue per month for 12 months. Once it has delivered the service for a year, the company will recognize the revenue of $120 as earned.
2. Accrued Revenue
Accrued revenue is the accrual or revenue that a company has earned for delivering a good/service, but the customer has yet to pay the amount for it. It’s the opposite of deferred revenue.
In this case, the revenue is considered earned and an asset as delivery is complete, even though the payment is not received. This type of accrual happens in cases such as loans and long-term projects. Here, the company will create an accrued revenue account to show the goods/services delivered and the payment to be received.
Example: Suppose a company delivered a product worth $1000 to a customer on credit card. It creates an accrued revenue account to show the amount to be received for the delivered product. Here, the revenue of $60 is still considered earned as the product is delivered even though the payment is due.
3. Prepaid Expenses
Prepaid expenses are accruals or expenses a company (X) pays in advance to another company (Y) before receiving the product or service from Y.
This means the expense has yet to be incurred and is considered an asset because X is to receive the deliverable. Here, Y will create a prepaid expense account to show the payment received for the service/product company X has to receive. Once X receives the deliverable, the expense will be incurred and realized.
Example: Suppose a company buys a yearly subscription of project management software at $120 or $10 per month. It’s an asset for the company as it’s entitled to the service for the whole year. The service provider creates a prepaid expense account for $120, reflecting the payment has been received, and the service is yet to be delivered. It reduces $10 per month for a year for the service delivered each month. Once complete, the expense is incurred officially.
4. Accrued Expenses
Accrued expenses are accruals or expenses a company has incurred for purchasing a product/service but hasn’t paid for it yet.
Here, the expense accruals are recorded as incurred in the financial statements since the company has received the product/service, even if the payment is due. At the same time, the expense is considered a liability because the company is obligated to pay for it in the future.
Example: Let’s say a company rents a building as its office for $3000 a month. It pays the rent only in the first week of the next month. This means the expense is incurred each month as the company utilizes the building each month.
Advantages of Accrual Accounting
The advantages of accrual accounting are:
- Provides complete and accurate financial insights into a business.
- Helps in making better, data-driven decisions, like financial planning, budgeting, and investing.
- Simplifies compliance with standards like GAAP and IFRS.
- Enhances cash flow management by matching expenses with revenue in the same period.
- Delivers consistent financial metrics, offering stability that attracts lenders and investors.
Disadvantages of Accrual Accounting
Here are some disadvantages of accrual accounting:
- Complex, resource-intensive, and time-consuming to implement.
- Prone to biases and errors due to subjective estimations.
- Poor cash flow management since immediate cash inflow/outflow isn’t tracked.
- Misleading results in the short term as real payments may not come for months.
- Taxes may be due on recognized income even if the cash has not been received yet.
What Is the Difference Between Accrual Accounting and Cash Accounting
Here are the differences between accrual and cash accounting methods based on the following parameters:
| Parameter | Accrual Accounting | Cash Accounting |
|---|---|---|
| Revenue Recognition | A company recognizes revenue when it’s earned by selling a product/service to a customer, whether the company has received the payment or not. | A company recognizes revenue only when it has received the payment/cash for the sold product or service from the customer. |
| Expense Recognition | A company recognizes expenses when it’s incurred by purchasing a product/service from a service provider, whether the company has made the payment or not. | A company recognizes expenses only when it pays for a product/service. |
| Regulatory Compliance | Regulatory bodies like GAAP and IFRS encourage people to follow this accounting method. Thus, achieving compliance is easier with accrual accounting. | Achieving compliance is difficult with the cash-basis accounting method as it provides less clarity on a company’s finances, including revenue, expenses, and profits. |
| Decision Making | You can calculate revenue, expenses, and profits with better accuracy with accrual accounting as expenses are recorded in the same financial period as revenue. This data allows you to make better financial decisions, like investment, budgeting, planning, etc. | This accounting method may not provide accurate financial data, which could affect your financial decision-making. l |
| Cash Flow Management | Accrual accounting offers full disclosure of cash inflow/outflow, so you’ll know the total revenue earned and expenses incurred in a financial period. This lets you manage cash flow better. | Without a full understanding or accuracy of your finances, managing cash flow becomes difficult for businesses. |
| Timing of Transactions | A company records transactions at the time they are earned or incurred, which lets you understand your financial position better. | A company records transactions at the time it receives or pays the cash, which focuses only on areas involving cash exchanges. |
| Suitable for | More suitable for enterprises or larger businesses working on credits or managing complex, long-term projects. | More suitable for smaller businesses, freelancers, and sole proprietors with short-term projects or simpler operations. |
Challenges of Accrual Accounting
The challenges of accrual accounting are:
- Focus on historical cost: Accrual accounting records financial transactions based on the asset’s historical cost instead of its present market value. This complicates accounting processes and may lead to inaccuracies and errors in financial reporting, especially when the market value fluctuates.
- Omission of intangible assets: Accrual accounting often omits intangible assets, such as intellectual property rights, brand reputation, etc., as their exact value is unclear. Despite being essential aspects of business success, financial reporting under accrual accounting doesn’t include them. As a result, stakeholders, especially lenders and investors, may not truly understand the company’s value, which influences their investment decisions.
- Neglect of time value of money (TVM): Accrual accounting overlooks the time value of money, meaning that money available now is more valuable than the same amount in the future due to potential investment returns. While accrual accounting records transactions when they occur, this may not reflect immediate cash availability, leading to delays in investment opportunities, reduced interest earnings, and slower financial growth.
- Oversimplification of complex transactions: Accrual accounting oversimplifies even the most complex transactions, like multi-year or long-term contracts, leases, derivatives, etc., and records them. It may not completely cover the underlying risks and obligations related to these complex transactions. As a result, a company will have no idea of the issues that may arise from these risks and how they affect the business.
- Lack of operational insights: Accrual accounting considers a company’s financial performance and not operational insights, like resource allocation, inventory status, staff requirements, etc. Even though a company might seem profitable from its balance sheet, ignored operational insights affect decision-making and business growth.
- Subjectivity in estimation: An organization using accrual accounting needs to make judgments and estimations when recognizing annual revenue, accrued expenses (like taxes), asset depreciation, bad debt amounts, etc. These judgments and estimations are subjective and may involve errors or certain biases, affecting the reliability, consistency, and stability of financial reporting.
When to Use Accrual Basis Accounting
Accrual basis accounting is preferred in the following scenarios:
- Businesses with long-term contracts like leases, subscription services, etc.
- Individuals and organizations handling complex transactions, like deferred revenue
- Businesses that sell their products/services on credit to get accurate financial status for revenue when it’s earned.
- Complex, vast business structures like companies with operations running worldwide, divisions in multiple locations, supply chains highly complicated, etc., to maintain consistent financial reporting everywhere
- Businesses, especially under heavily regulated industries like banking, finance, healthcare, etc., to meet regulatory compliance such as GAAP and IFRS requirements
- Organizations with seasonal revenues to get complete and accurate insights into their finances and understand profitability
Examples of Accrual Accounting
Let’s check out the below accrual accounting examples:
Revenue Examples
An organization sold $100 worth of shoes to a customer in August 2024 but received the payment in September 2024.
If you follow the accrual accounting method, the organization must recognize revenue from the sold product in August 2024 since the transaction occurred in that month only, even if it was paid the following month.
Other examples:
- A bank records loan interests in the same accounting period as the outstanding principal, but the borrower still pays it later.
- An agency completed $500 worth of work in June 2024, but the client cleared the payment only in July 2024. The agency will record the revenue in June and not in July when it was actually paid.
Expense Examples
A company paid its expenses like rent, employee salaries, and electricity bills for August 2024 in the next month.
Following the accrual accounting method, the organization must recognize the expenses in August 2024 only as the actual expenses incurred in the same month, no matter when they were paid.
Other examples:
- A company pays for its income tax on revenue according to the mandates and set timelines of the governing bodies. However, it will recognize the tax in the same accounting period as the realized revenue.
- A company records its employee benefits expenses in the applicable period, even if it pays for it later.