What Is Accrual Accounting?
Accrual accounting is a financial accounting method that allows a company to record revenue before receiving payment for goods or services sold and record expenses as they are incurred.
In other words, revenue earned and expenses incurred are entered into the company’s journal regardless of when money exchanges hands. Accrual accounting is usually compared to cash basis accounting, which records revenues only when payments are received and expenses only when payments are made.
Key Takeaways
- Accrual accounting records revenues and expenses when they are earned or incurred, not when cash is exchanged.
- The method follows the matching principle, ensuring that revenues and expenses are recorded in the same period.
- Accrual accounting uses the double-entry accounting method.
- It is required for companies with average revenues of $25 million or more over three years.
- Cash accounting is another method, recognizing transactions only when payment is exchanged.
How Accrual Accounting Works
The essence of accrual accounting is that entries are made when a good or service is provided, irrespective of when payment is made or received. This offers a more accurate picture of a company’s current and long-term financial health by combining current and future cash inflows or outflows.
Accrual accounting adheres to the matching principle, recording revenues and expenses in the same period. It’s encouraged by both International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) and is the standard practice for most corporations, excluding small businesses and individuals.
Qualifying for Accrual Accounting
Companies with average gross revenues exceeding $25 million over the past three years are required to use the accrual method. Smaller companies can choose between the cash basis and accrual accounting methods. Companies dealing with inventory or sales on credit must use accrual accounting regardless of size or revenue.
Benefits of Accrual Accounting
Accrual accounting provides a more accurate picture of a company’s financial condition, although it is more complicated and costlier to implement. Its accuracy stems from reflecting long-term revenue streams and selling on credit. This method allows businesses to better manage current resources and plan for the future, despite its complexity.
Accrual Accounting vs. Cash Accounting
Accrual accounting contrasts with cash accounting, which only recognizes transactions when cash is exchanged.
Cash Basis of Accounting
Imagine a consulting firm that provided services worth $5,000 on Oct. 30. If the client pays on Nov. 25, the cash method would record the revenue on that payment date, providing a straightforward but potentially misleading financial picture.
Accrual Basis of Accounting
Conversely, using accrual accounting, the consulting firm would record the $5,000 as accounts receivable on Oct. 30. Once payment is received on Nov. 25, the accounts receivable and service revenues accounts are adjusted accordingly, offering a detailed and ongoing financial viewpoint.
Explaining Accrual Accounting to Non-Accountants
Accrual accounting uses double-entry methods, recording transactions when they are initiated rather than when payments are made. Thus, it provides an accurate reflection of incurred debts and future revenues.
Differences Between Accrual and Cash Accounting
Cash accounting records transactions when payments are received or made. In contrast, accrual accounting records transactions when services or goods are provided or debt is incurred.
What Is an Accrual Journal Entry?
An accrual or journal entry marks the point at which a transaction occurs, ensuring real-time tracking of expenses and revenues.
Three Accounting Methods
The three primary accounting methods are cash basis, accrual basis, and a hybrid known as the modified cash basis.
The Bottom Line
Accrual accounting, recording payments and expenses when earned or incurred, differs from cash accounting, which records only when cash changes hands. With its double-entry accounting system, accrual accounting offers greater accuracy by tracking capital movement and helping prepare reliable financial statements.
Related Terms: Cash Basis Accounting, Financial Statements, Revenue Recognition, Expenses.
References
- Internal Revenue Service. “FAQs Regarding the Aggregation Rules Under Section 448(c)(2) That Apply to the Section 163(j) Small Business Exemption”.
- Internal Revenue Service. “Rev. Proc. 2022-09”, Page 2.
- Internal Revenue Service. “Publication 538 (01/2022), Accounting Periods and Methods”.
