What is accrual accounting (short definition)
– Accrual accounting is a bookkeeping approach that records revenue when it is earned and expenses when they are incurred, regardless of when cash actually changes hands. The method captures economic events at the time the business obligation arises, not only when payments are received or made.
Key concepts and jargon (defined)
– Matching principle: Revenues and the expenses that generate them should be recognized in the same reporting period so profit is measured accurately for that period.
– Double-entry accounting: Every transaction affects at least two accounts (one debit and one credit), keeping the accounting equation balanced.
– Accounts receivable: Money owed to the business for goods or services already delivered.
– Accounts payable (or other payables): Obligations the business has incurred but not yet paid.
– Accrual journal entry: The initial record made in the accounting journal to reflect revenue earned or expense incurred before cash flow occurs.
How accrual accounting works (step-by-step)
1. A transaction occurs (a sale, a service performed, or an expense incurred).
2. Record an accrual journal entry that recognizes the revenue or expense now:
– For a sale on credit: debit Accounts Receivable (asset) and credit Revenue (income).
– For an expense not yet paid: debit Expense and credit Accounts Payable (liability).
3. When cash is later received or paid, record the cash transaction and reverse or clear the related receivable/payable.
4. Summarize accruals in financial statements: balance sheet shows receivables and payables; income statement shows revenues and expenses for the period.
Accrual vs. cash accounting (brief comparison)
– Cash basis: recognize revenue and expenses only when cash is received or paid. Simpler; commonly used by very small businesses.
– Accrual basis: recognize when earned/incurred. Provides a clearer picture of ongoing financial performance but requires more recordkeeping.
– Modified cash basis (hybrid): a mix of the two—cash basis for some items and accrual for others.
Who typically uses accrual accounting (qualifying rules)
– Generally required under GAAP (U.S. Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) for most companies.
– U.S. tax rules require accrual for many businesses: for example, businesses carrying inventory or making frequent credit sales must use accrual accounting regardless of size. Also, businesses with average gross receipts above a statutory threshold over recent years may be required to use accrual methods for tax purposes. (See IRS guidance for current thresholds and exceptions.)
Benefits and trade-offs
– Benefits: better matching of revenues and expenses, improved visibility into future cash inflows and outflows, financial statements that reflect economic activity rather than cash timing.
– Trade-offs: more complex bookkeeping, greater need for systems and controls, and potentially higher accounting costs.
Quick checklist: Is accrual accounting right for you?
– Do you sell on credit or carry inventory? If yes → accrual is appropriate or required.
– Do you need financial statements that reflect performance by period rather than cash timing? If yes → accrual is better.
– Is your business large or growing (complex transactions)? Consider accrual.
– Do you prefer simpler records and mostly immediate cash transactions? Cash basis may suffice for very small operations.
– Are you subject to GAAP/IFRS reporting or certain tax rules? Confirm regulatory requirements.
– Do you have software and staff (or an accountant) who can manage accrual entries? If not, plan for implementation costs.
Worked numeric examples (two short illustrations)
Example A — Revenue on credit (consulting work)
– Scenario: A consultant completes a $5,000 engagement on Oct 30 and invoices the client. The client pays on Nov 25.
– Oct 30 (when service is delivered — accrual entry):
– Debit Accounts Receivable $5,000
– Credit Service Revenue $5,000
– Effect: Income recognized in October; asset shows money owed.
– Nov 25 (when cash arrives):
– Debit Cash $5,000
– Credit Accounts Receivable $5,000
– Effect: Cash increases; receivable cleared. No new revenue recorded on Nov 25.
Example B — Expense incurred but paid later (utility bill)
– Scenario: A company incurs a $1,200 utility bill on Dec 31 but pays it on Jan 15.
– Dec 31 (expense incurred — accrual entry):
– Debit Utilities Expense $1,200
– Credit Utilities Payable (or Accounts Payable) $1,200
– Effect: Expense shows in December; liability recorded.
– Jan 15 (cash payment):
– Debit Utilities Payable $1,200
– Credit Cash $1,200
– Effect: Liability cleared; cash reduced.
Three accounting methods (summary)
– Cash basis: recognize transactions when cash is exchanged.
– Accrual basis: recognize transactions when economic events occur (earned/incurred).
– Modified cash basis: a hybrid that applies aspects of both methods (often used by smaller entities transitioning toward accrual reporting).
Practical notes and implementation tips
– Use reliable accounting software that supports receivables/payables and reversing entries.
– Reconcile receivables, payables, and accruals regularly (monthly recommended).
– Document the policies you follow for recognizing revenue and expenses to ensure consistent reporting.
– Train staff on debit/credit impacts and the timing of journal entries.
Reputable sources for further reading
– Investopedia — Accrual Accounting overview: https://www.investopedia.com/terms/a/accrualaccounting.asp
– U.S. Internal Revenue Service — Publication 538, Accounting Periods and Methods: https://www.irs.gov/publications/p538
– IFRS Foundation — International Financial Reporting Standards: https://www.ifrs.org
– Financial Accounting Standards Board (FASB) — U.S. GAAP resources: https://www.fasb.org
Educational disclaimer
This explainer is for educational purposes and does not constitute personalized accounting, tax, or investment advice. For decisions that affect taxes, reporting, or compliance, consult a qualified accountant or tax professional.