What is Accrual Accounting?

Accrual Accounting Definition

Accrual accounting is an accounting method that records revenues and expenses when they are earned or incurred, regardless of when the cash transaction occurs. This approach differs from cash accounting, where revenues and expenses are recorded only when cash is received or paid. Accrual accounting provides a more accurate picture of a company's financial position and performance by recognizing economic events in the periods in which they occur, not necessarily when cash changes hands.

Accrual Accounting Components

Here are the components involved in the accrual accounting method:

• Revenue Recognition: Under the accrual accounting system, revenues recognition happens when they are earned, not when the payment is received, and this is known as accrued revenue (different from unearned revenue). For example, a service company would record revenue when the service is provided, even if the customer will pay at a later date.
• Expense Recognition: Expense recognition is when the expense is recorded when incurred, not necessarily when paid. For example, a business would recognize an expense for goods or services it has received, even if the payment to the supplier is due at a later date (accrued expense).
• Matching Principle: This principle is a cornerstone of accrual accounting. It states that expenses should be matched with the revenues they help to generate. For example, the cost of goods sold is recorded in the same period as the revenue from those goods, ensuring that financial statements reflect the true costs associated with generating revenue in a period.
• Adjusting Entries: Accrual accounting often requires an adjusting entry at the end of an accounting period to record revenues and expenses in the correct period. These adjustments ensure that the financial statements comply with the matching principle.
• Balance Sheet and Income Statement: Accrual accounting affects the balance sheet and the income statement. Accounts receivable and accounts payable are examples of balance sheet items that reflect accrual for revenues and expenses, respectively.

Example of Accrual Accounting

For instance, if a company delivers a product or service, it would record the revenue, even if the customer pays at a later date. Similarly, expenses are recorded when they are incurred, not when they are paid. 

Benefits of Accrual Accounting

Accrual accounting offers considerable benefits, particularly in providing a more accurate and comprehensive picture company health and performance. 

• Financial Position: Accrual basis accounting gives a more realistic idea of income and expenses during a period, which helps in understanding the actual profitability of the business. This is because it records revenues and expenses when they are earned or incurred, not just when cash is exchanged.
• Better Decisions: By providing a more accurate financial picture, accrual accounting enables better decision-making by management. It helps in assessing the performance and health of the business over a period, rather than merely tracking cash flow.
• Compliance and Comparability: For businesses that are required to follow Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), accrual accounting is necessary. This compliance ensures that the financial statements are comparable with those of other companies, which is important for investors, creditors, and other stakeholders.
• Revenue and Expense Matching: Accrual accounting allows for the matching of revenues with expenses in the period in which they are incurred, regardless of when cash transactions occur. This matching principle helps in accurately determining profits for a specific period, leading to a better understanding of business performance.
• Better Planning: Because accrual accounting provides a more comprehensive view of a company's assets and liabilities, it aids in more effective long-term financial planning and analysis.
• Creditworthiness Assessment: For businesses seeking loans or investments, accrual accounting provides financial statements that better reflect the company's ability to cash flow forecast, which is often a key consideration for lenders and investors.
• Minimizes Misleading Results: By recording transactions when they occur rather than when cash is exchanged, accrual accounting avoids the potential for cash accounting to present a misleading picture of a company's health—such as showing high cash inflows when in reality the business is not profitable.
• Detailed Financial Analysis: Accrual accounting allows for a more detailed financial analysis, as it provides information about accounts receivable and payable, revenue yet to be received, and expenses yet to be paid.

Accrued Revenue and Accrued Expense

Accrued Revenue and Accrued Expense are two key concepts in accrual accounting, essential for understanding how businesses record their financial transactions to reflect their economic activities.

Accrued Revenue

• Definition: Accrued revenue refers to revenue that has been earned but not yet received in cash or recorded. This situation arises when a company provides goods or services to a customer but has not yet billed the customer or received payment.
• Example: Imagine a software company that has provided a year-long subscription service to a customer. The service is delivered over the year, but the customer is billed quarterly. At the end of each month, the company has earned a portion of the subscription fee, even though it hasn't billed the customer yet. This unbilled amount is recorded as accrued revenue.
• Accounting Treatment: In financial statements, accrued revenues are recorded as assets (accounts receivable) in the journal entry because they represent funds that the company expects to receive. They are also recognized as revenue on the income statement, reflecting the earnings that have occurred, even though cash hasn't been received.

Accrued Expense

• Definition: Accrued expense refers to an expense that has been incurred but not yet paid in cash or recorded. It represents a company's obligation to pay for goods or services that have been received but are not yet billed or paid for and is recorded as an accounts payable in the journal entry.
• Example: Consider a company that uses electricity for its operations. The electricity is consumed throughout the month, but the bill isn't received until the following month. The cost of the electricity used, but not yet paid for by the end of the month, is an accrued expense.
• Accounting Treatment: Accrued expenses are recorded as liabilities during balance sheet reconciliation because they represent future cash outflows that the company must make. On the income statement, they are recognized as expenses in the period in which they occur, not when they are paid. This recognition aligns with the matching principle of accounting, which states that expenses should be matched with the revenues they help to generate in the same period.

Both accrued revenue and accrued expense are crucial for ensuring that financial statements under accrual accounting accurately represent a company's financial position and performance. They ensure that income and expenses are recorded in the period in which they are earned or incurred, providing a realistic picture of the company's financial results and obligations.

Accrual Accounting vs. Cash Basis Accounting

Accrual accounting records revenues and expenses when they are earned or incurred, regardless of when the transaction takes place. This approach adheres to the matching principle, which states that expenses should be matched with the revenues they help to generate in the same period.

Accrual accounting is more complex than cash based accounting and is used by companies that have more than a minimal amount of inventory and accounts receivable.

Cash basis accounting is simpler and records transactions only when cash changes hands. Revenue is recorded when cash is received, and expenses are recorded when they are paid. Cash method is often used by small businesses and individual proprietors because of its simplicity and ease of understanding. 

For example, if a company receives payment for a service in a particular month, the revenue is recognized in that month, regardless of when the service was performed. Similarly, expenses are recognized when they are paid, not when they are incurred. While cash based accounting is easier to maintain, it can sometimes present a misleading view, especially if large amounts of revenue or expenses are expected but haven't yet been transacted in cash.