What Is Accrual Accounting, and How Does It Work?

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, the 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 of accounting, which records revenue when the goods and services are actually paid for.

Learn more about accrual accounting and how it differs from the other popular accounting method, cash accounting.

How Accrual Accounting Works

The general concept of accrual accounting is that accounting journal entries are made when a good or service is provided rather than when payment is made or received. Entries are also made for debts and payments due.

This method allows the current and future cash inflows or outflows to be combined to give a more accurate picture of a company's current and long-term finances.

Accrual accounting follows the matching principle, which states that revenues and expenses should be recorded in the same period.

Accrual accounting is encouraged by International Financial Reporting Standards(IFRS) and Generally Accepted Accounting Principles (GAAP). As a result, it has become the standard accounting practice for most companies except for very small businesses and individuals.

Qualifying for Accrual Accounting

Larger companies are required to use the accrual method of accounting if their average gross receipt of revenues is more than $25 million over the previous three years. If a company does not meet the average revenue requirement, it can choose to use cash basis or accrual as its accounting method.

Accrual accounting is always required for companies that carry inventory or make sales on credit, regardless of the company size or revenue.

Benefits of Accrual Accounting

The accrual method does provide a more accurate picture of the company's current condition, but its relative complexity makes it more expensive to implement.

This method arose from the increasing complexity of business transactions and a desire for more accurate financial information. Selling on credit and projects that provide revenue streams over a long period affect a company's financial condition at the time of a transaction. Therefore, it makes sense that such events should also be reflected in the financial statements during the same reporting period that these transactions occur.

Under accrual accounting, firms have immediate feedback on their expected cash inflows and outflows, making it easier for businesses to manage their current resources and plan for the future.

Accrual Accounting vs. Cash Accounting

Accrual accounting can be contrasted with cash accounting, which recognizes transactions only when there is an exchange of cash. Additionally, cash basis and accrual differ in the way and time transactions are entered.

Cash Basis of Accounting

Cash accounting uses transactions when payments are made. For example, consider a consulting company that provides a $5,000 service to a client on Oct. 30. The client received the bill for services rendered and made a cash payment on Nov. 25. Under the cash basis method, the consultant would record an owed amount of $5,000 by the client on Oct. 30, and enter $5,000 in revenue when it is paid on Nov. 25 and record it as paid.

Accrual Basis of Accounting

When the consulting company provided the service, it would enter a debit of $5,000 in accounts receivable (debits increase an asset account) and a credit of $5,000 in the service revenues account (credits increase a revenue account). When the payment is made on Nov. 25, the consultant credits (credits decrease an asset account) the accounts receivable by $5,000 and debits (debits increase an asset account) cash with $5,000.

The received capital can then be moved to other accounts, such as free cash, if needed—the company uses the same double-entry method to enter which account the capital came from and is moved to.

The Bottom Line

Accrual accounting is an accounting method in which payments and expenses are credited and debited when earned or incurred. Accrual accounting differs from cash basis accounting, where expenses are recorded when payment is made and revenues are recorded when cash is received.

Accrual accounting uses double-entry accounting, where there are generally two accounts used when entering a transaction. This method is more accurate than cash basis accounting because it tracks the movement of capital through a company and helps it prepare its financial statements.