Accrual basis accounting is one of two leading accounting methods and the preferred bookkeeping method for providing an accurate financial picture of a company’s business operations.
Accrual basis accounting recognizes business revenue and matching expenses when they are generated—not when money actually changes hands. This means companies record revenue when it is earned, not when the company collects the money. It also means recognizing expenses when the company incurs the liability for them, not when it pays them.
- Accrual basis accounting creates a more accurate view of a company’s financial status by recording revenue when it is earned and expenses when they are incurred—effectively matching revenue with expense.
- Under this method, companies record revenue and expenses using balance sheet accounts like accounts receivable, accounts payable, prepaid assets and accrued expenses.
- Cash basis accounting is a viable alternative for some small businesses. It generally makes bookkeeping simpler.
What Is Accrual Basis Accounting?
Accrual basis accounting combines two key accounting principles: the matching principle and the revenue recognition principle. The matching principle says that expenses should be recognized in the same period as the revenue they help generate. The revenue recognition principle states that revenue should be recognized when it is earned or realized, i.e. when a business performs the actions that entitles it to the revenue.
Accrual accounting generally makes the relationships between revenue and expenses clearer, providing better insight into profitability. It also offers a more accurate picture of a company’s assets and liabilities on its balance sheet. For these reasons, accrual basis accounting is the only method allowed under General Accepted Accounting Principles (GAAP) and is required by the Securities and Exchange Commission (SEC) for publicly traded companies.
How Does Accrual Accounting Work?
In accrual accounting, a company recognizes revenue during the period it is earned, and recognizes expenses when they are incurred. This is often before—or sometimes after—it actually receives or dispenses money.
Accrual accounting works by recording accruals on the balance sheet that act like placeholders for cash events. For example, accounts receivable is an asset account that reflects revenue a company has earned but hasn’t yet been paid for. Similarly, accounts payable is a liability account that reflects amounts the business owes but hasn’t yet paid.
Accrual vs. Cash Accounting
The alternative to accrual accounting is called cash accounting.
What Is Cash Accounting?
Cash basis accounting tends to be used by small businesses and organizations that pay taxes via their owner(s) personal tax returns. Under the cash basis method, revenue and expenses are recorded based solely on cash flow. Revenue is reflected when the company receives cash from a customer, and expenses are recorded when cash is paid out. This makes bookkeeping under the cash basis accounting method very straightforward and tracking cash flow simple.
The timing of when revenue and expenses are recorded can result in big swings in earnings from reporting period to the next. Since accrual accounting doesn’t factor in when money actually changes hands, it reduces the impact of timing on a company’s financial records. For instance, consider a software company that sells a five-year subscription to its solution and receives the full payment as a cash sum at the start of the subscription. With cash-based accounting, it would record all the revenue during the first period and nothing for the next five years, which could lead to vastly different numbers in two consecutive reporting periods. With accrual-based accounting, the company spreads out that revenue over the length of the subscription to smooth out the impact of that transaction.
The differences between accrual and cash accounting also have significant tax implications. For example, a potential tax consequence of accrual accounting is that tax payments may be due on revenue that has been recognized, even though the company has not yet received the cash for some of those transactions.
Examples of Accrual Accounting
Revenue Example: A simple example of accrual accounting for revenue is when a company makes a sale to a customer on trade credit, meaning the buyer pays the seller within a set period of time after the transaction. In this case, revenue is earned before cash is received—primarily when goods change hands or a service has been performed.
Tom’s Services delivered IT services worth $5,000 to customer Smith’s Computers on February 10. Tom’s Services sends Smith’s Computers a bill when it produces invoices at the end of that month, on February 28—and if you’re using a cloud-based accounting system, the revenue is recognized when the transaction is recorded.
Tom’s Services invoice terms require payment within 30 days. Smith’s Computers sends a check to Tom’s on March 15, which is deposited the same day by Services Inc.
Here are Tom’s Services accounts receivable and cash journal entries for this transaction:
Expenses Example: A common example of accrual accounting for expenses is when a company buys inventory on credit.
Sport’s World, a sporting goods store, receives $5,000 worth of soccer balls from manufacturer Soccer Experts on March 1, and stocks them on its shelves in advance of the soccer season. Sport’s World receives an invoice from Soccer Experts on April 5, which it pays on April 10.
Sport’s World accounts payable and cash journal entries for this transaction are:
Other examples: There are many other ways revenue and expenses are recognized with accrual accounting. A few other use cases:
- If annual or multi-year contracts, memberships or subscriptions are paid in a single lump sum, the revenue or expense is spread across multiple periods over the life of the contract or subscription.
- For payroll, vacation or employee benefits that accumulate between payroll cycles, the company recognizes each expense during the period it applies to, even though it pays the expense later.
- When utilities or rent are billed after the period to which they apply, the company accrues the expense during the period that it uses the utilities or rented property.
- For income tax or sales tax due on revenue, the company recognizes the tax during the same period it recognizes the revenue, even though it pays the tax when required by the IRS.
- Interest on loans is recorded during the period the principal is outstanding, even though it is paid at a later date.
When to Use Accrual Basis Accounting
Accrual accounting must be used for any regulatory filing that requires GAAP, such as a company’s annual 10-K filing to the SEC. Most investors, lenders and financial institutions require GAAP financial statements when evaluating a business, which is a major reason why accrual accounting is the more popular method.
However, a few exceptions do exist, largely around income taxes. The Internal Revenue Service (IRS) allows small businesses with less than $25 million in annual revenue to use either accrual or cash basis accounting. Sole proprietors, partnerships and S-Corps are also allowed to use cash accounting. Note that changing your accounting method requires additional filing requirements with the IRS.
Advantages of Accrual Accounting
Accrual accounting is the preferred method of accounting for most businesses because it offers a more accurate representation of a company’s finances. Investors and lenders may require this method, and even if they don’t, the consistency of key metrics could make your business look more stable and increase the chances of receiving funding. Additionally, accrual accounting makes you GAAP compliant, which is a best practice, and could become important down the line.
Even startups that start out using the cash method due to its simplicity, tend to eventually move to accrual basis accounting when it comes time to apply for outside funding. So even if you don’t follow this standard now, you will likely have to in the future.
Is Accrual Accounting Right for Your Business?
If your business relies entirely on cash payments, both for revenue and for expenses, then accrual accounting may not be right for your business. For most other businesses—those that extend credit to customers or use credit with their suppliers—accrual accounting gives a more accurate picture of their overall financial health. In general, the greater the lag in payment time, the stronger the argument for accrual based accounting. Products-based businesses that carry inventory, even if they’re small, usually use accrual accounting because the cash method doesn’t properly account for cost of goods sold and sinks gross profit.
In addition, any companies with more than $25 million in revenue or that are publicly traded must use accrual accounting. So once your business reaches a certain stage, this accounting method is a requirement.
How Does Accounting Software Help With Accrual-Based Accounting?
One of the biggest reasons businesses hesitate to use accrual accounting is the time and effort required to maintain the books and records. It is more complex to manage accounts receivable, accounts payable and prepaid or deferred assets than to simply track cash in and cash out under the cash basis method. Additionally, the accrual method requires companies to close the books more frequently (i.e. monthly, rather than annually). Further, companies generally manage subsidiary ledgers like accounts receivable and accounts payable more frequently, on a weekly or biweekly basis.
This potential obstacle to adopting accrual accounting is greatly reduced by implementing accounting software, which can automate and streamline the process, reducing errors and staff cost. Recurring journal entries, subsidiary ledger reconciliations and balancing—all key components of accrual accounting—are included in the core functionality of most accounting software and simplify accrual accounting.