What is Accrual Accounting?

Accrual accounting is more like a business diary than a tally sheet...

Cash accounting is not much different than keeping a record of your debit card deposits and withdrawals. But accrual accounting keeps track of every move a business makes, even if no cash is exchanged. A company's general ledger will provide a more accurate picture if it tells the story of money owed, sales on credit, and the status of inventory throughout the business cycle.

The accrual method of accounting is an accounting method of bookkeeping that keeps track of all business transactions with journal entries in a general ledger at the time they occur, whether or not a cash payment has been exchanged. Revenue is recognized when it's earned, and expenses are noted when they're incurred. Accrual accounting is often compared to cash accounting, which only keeps track of business events in which cash is exchanged.

If you use the accrual basis of accounting and you sell a product on credit, your journal entry will record the date of the transaction as the date of the sale — not when you're paid for the product. The entry would be listed as a current asset, even though your customer may still owe you. Similarly, if you bought supplies on credit, you'd record the expense on the date you purchased the supplies, not the date you paid for them.

Businesses that keep an inventory or buy and sell on credit generally use the accrual method to keep track of their assets and liabilities. Accrual accounting gives a more accurate picture of a business's overall profitability than the cash method because it matches revenues and the expenses related to them in the same accounting period. Investors can get a feel for a company's profitability through its business activity during different accounting periods by examining its financial records.

An accrual is a single recorded transaction representing either revenue earned or an expense incurred, whether or not cash is involved. Accruals influence the amount of net income a company reports on its income statement and balance sheet for a given period.

Examples of accruals in accounting are accrued revenue, such as accounts receivable (money owed to you for selling on credit) and accrued interest (the interest you earned for a period that the bank hasn't paid you yet). Accrued expenses are expenses incurred that you haven't paid yet, such as accounts payable (money you owe for purchases on credit) and accrued tax (taxes you owe).

A sister term to an accrual is a deferral. Deferrals are transactions recorded in one accounting period that won't be earned until a later accounting period. Deferrals can also be revenue or expenses. Deferred revenue is when a customer pays you before you perform a service, such as a retainer. Deferred expenses can be things like rent or insurance premiums that cover months to come.

Businesses use accrual accounting by making journal entries in their company's general ledger to keep track of revenue and expenses in the same accounting period that they perform the service, sell the product, or run up the expense.

For example, say you are a seamstress. You receive an order from a customer to make a dress in June, but the customer will pay you $500 for the dress in July. You purchase the material and supplies you need for $150 on credit in June, but you won't pay for them until the following month. Even though you won't be paid for the dress or billed for the supplies until July, your journal entries reflect the business activity in June.

You record revenue of $500, expenses of $150, and profit of $350 for June (assuming no other costs), even though cash for the transactions won't move in and out of the company until July.

Accrual accounting allows you to track the business operation — the creation and sale of the dress — in the month that it occurred, which gives you a more accurate picture of your business's activity during that accounting period.

The revenue recognition principle states that revenue is recognized as its earned, not when cash is received.

The matching principle of accounting stipulates that the revenue generated — and the expenses incurred to create that revenue — need to be recognized in the same accounting period.

The accrual principle says that you need to record all business transactions in the time period that they occur, not when the cash transactions related to them take place.

The accrual principle is supported by the Generally Accepted Accounting Principles (GAAP) of the US and the International Financial Reporting Standards (IFRS) used for foreign companies and some US subsidies overseas, which regulate how public companies must report financials.

Whether a business uses accrual accounting or cash accounting depends upon its size and complexity. The IRS states that private companies can use whatever accounting method they want, but they have to pick one and stick with it. However, the SEC requires publicly traded companies to use accrual accounting for their financial statements.

If a company’s sales revenue is higher than $25M for the prior three year period, the IRS requires the accrual method of accounting (excluding S corporations which can continue to use cash accounting).

Most businesses must use accrual accounting to report their profits over a period of time accurately. Companies that have a large sales volume, hold inventory, or buy and sell on credit generally use the accrual accounting method to keep track of their sales volume and profits.

Cash accounting is easy and straightforward. Only transactions where cash is received or paid out are recorded. Cash accounting may be sufficient for small businesses, but it is generally too limited to handle the needs of more sophisticated companies. Revenue earned, and the expenses paid that relate to that revenue, can end up in different accounting periods, which can distort profit periods. It’s harder to track inventory or anything bought or sold on credit. With cash accounting, you only pay taxes on the cash you've received, even if you're still owed money from a sale generated during that tax period.

Cash Accounting Pros

• Easier than accrual accounting
• Suitable for small businesses that aren’t too complex
• Acceptable standard under accounting standards set by Generally Accepted Accounting Principles (GAAP) in the US and the International Financial Reporting Standards (IFRS) globally for small private companies with annual sales under a certain threshold

Cash Accounting Cons

• Doesn't account for inventory
• Doesn't acknowledge money owed to a business
• Doesn't recognize money a company owes
• Doesn't give an accurate way to record overall profits for a given period
• Can't be used by businesses that have generated over $25M in gross receipts for the prior three years per the IRS (excluding S corporations) or are publicly-traded

The accrual method of accounting identifies income and expenses, whether cash is involved or not. It's more accurate at evaluating a company's overall performance, which allows it to provide a transparent picture of a company's financials to its investors over a given period. With accrual accounting, you must pay taxes on income that you might not have received yet.

Accrual Accounting Pros

• Applies the matching principle — expenses and revenue are matched in related periods
• Keeps track of accounts receivable and accounts payable, which gives a transparent picture of a business's financial position
• Offers investors a broader view of a company's profitability over time

Accrual Accounting Cons

• More complicated than cash accounting because you have to make assumptions and estimates
• You may have tax liability for reported income that hasn’t been paid yet
• May require the additional expense for the services of professional accountants