Count on Accrual-Based Accounting (2024)

Accrual basis accounting is one of two leading accounting methods and the preferredbookkeeping method for providing an accurate financial picture of a company’s businessoperations.

Accrual basis accounting recognizes business revenue and matching expenses when they aregenerated—not when money actually changes hands. This means companies record revenuewhen itis earned, not when the company collects the money. It also means recognizing expenses whenthe company incurs the liability for them, not when it pays them.

Key Takeaways

• Accrual basis accounting creates a more accurate view of a company’s financialstatus byrecording revenue when it is earned and expenses when they areincurred—effectivelymatching revenue with expense.
• Under this method, companies record revenue and expenses using balance sheet accountslike accounts receivable, accounts payable, prepaid assets and accrued expenses.
• Cash basis accounting is a viable alternative for some small businesses. It generallymakes bookkeeping simpler.

What Is Accrual Basis Accounting?

Accrual basis accounting combines two key accounting principles: the matching principle andthe revenue recognition principle. The matching principle says that expenses should berecognized in the same period as the revenue they help generate. The revenue recognitionprinciple states that revenue should be recognized when it is earned or realized, i.e. whena 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 acompany’s assets and liabilities on its balance sheet. For these reasons, accrualbasisaccounting is the only method allowed under General Accepted AccountingPrinciples (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, andrecognizes expenses when they are incurred. This is often before—or sometimesafter—itactually receives or dispenses money.

Accrual accounting works by recording accruals on the balance sheet that act likeplaceholders for cash events. For example, accounts receivable isan asset account that reflects revenue a company has earned but hasn’t yet been paidfor.Similarly, accounts payable is aliability 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 taxesvia their owner(s) personal tax returns. Under the cash basis method, revenue and expensesare recorded based solely on cash flow. Revenue is reflected when the company receives cashfrom a customer, and expenses are recorded when cash is paid out. This makes bookkeepingunder 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 earningsfrom reporting period to the next. Since accrual accounting doesn’t factor in whenmoneyactually changes hands, it reduces the impact of timing on a company’s financialrecords.For instance, consider a software company that sells a five-year subscription to itssolution and receives the full payment as a cash sum at the start of the subscription. Withcash-based accounting, it would record all the revenue during the first period and nothingfor the next five years, which could lead to vastly different numbers in two consecutivereporting periods. With accrual-based accounting, the company spreads out that revenue overthe length of the subscription to smooth out the impact of that transaction.

Tax Implications

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 bedue on revenue that has been recognized, even though the company has not yet received thecash for some of those transactions.

Examples of Accrual Accounting

Revenue Example: A simple example of accrual accounting for revenue is whena company makes a sale to a customer on trade credit, meaning the buyer pays the sellerwithin a set period of time after the transaction. In this case, revenue is earned beforecash 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 Computerson February10. Tom’s Services sends Smith’s Computers a bill when it produces invoices atthe end ofthat month, on February 28—and if you’re using a cloud-based accounting system,the revenueis recognized when the transaction is recorded.

Tom’s Services invoice terms require payment within 30 days. Smith’s Computerssends a checkto 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 thistransaction:

Expenses Example: A common example of accrual accounting for expenses iswhen a company buys inventory on credit.

Sport’s World, a sporting goods store, receives $5,000 worth of soccer balls frommanufacturer Soccer Experts on March 1, and stocks them on its shelves in advance of thesoccer season. Sport’s World receives an invoice from Soccer Experts on April 5, whichitpays 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 arerecognized with accrual accounting. A few other use cases:

• If annual or multi-year contracts, memberships or subscriptions are paid in a singlelump sum, the revenue or expense is spread across multiple periods over the life of thecontract or subscription.
• For payroll, vacation or employee benefits that accumulate between payroll cycles, thecompany recognizes each expense during the period it applies to, even though it pays theexpense later.
• When utilities or rent are billed after the period to which they apply, the companyaccrues 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 thesame period it recognizes the revenue, even though it pays the tax when required by theIRS.
• Interest on loans is recorded during the period the principal is outstanding, eventhough 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 acompany’s annual 10-K filing to the SEC. Most investors, lenders and financialinstitutionsrequire GAAP financial statements when evaluating a business, which is a major reason whyaccrual 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 eitheraccrual or cash basis accounting. Sole proprietors, partnerships and S-Corps are alsoallowed to use cash accounting. Note that changing your accounting method requiresadditional filing requirements with the IRS.

Advantages of Accrual Accounting

Accrual accounting is the preferred method of accounting for most businesses because itoffers a more accurate representation of a company’s finances. Investors and lendersmayrequire this method, and even if they don’t, the consistency of key metrics could makeyourbusiness look more stable and increase the chances of receiving funding. Additionally,accrual accounting makes you GAAP compliant, which is a best practice, and could becomeimportant down the line.

Even startups that start out using the cash method due to its simplicity, tend to eventuallymove to accrual basis accounting when it comes time to apply for outside funding. So even ifyou 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, thenaccrual accounting may not be right for your business. For most other businesses—thosethatextend credit to customers or use credit with their suppliers—accrual accounting givesamore accurate picture of their overall financial health. In general, the greater the lag inpayment time, the stronger the argument for accrual based accounting. Products-basedbusinesses that carry inventory, even if they’re small, usually use accrual accountingbecause 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 tradedmust use accrual accounting. So once your business reaches a certain stage, this accountingmethod 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 andeffort required to maintain the books and records. It is more complex to manage accountsreceivable, accounts payable and prepaid or deferred assets than to simply track cash in andcash out under the cash basis method. Additionally, the accrual method requires companies toclose the books more frequently (i.e. monthly, rather than annually). Further, companiesgenerally manage subsidiary ledgers like accounts receivable and accounts payable morefrequently, 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. Recurringjournal entries, subsidiary ledger reconciliations and balancing—all key components ofaccrual accounting—are included in the core functionality of most accounting software andsimplify accrual accounting.