What Does Accrual Mean in Accounting?
Understand accrual accounting, the method that accurately reflects a business's financial performance by recognizing revenues and expenses when earned or incurred, not just when cash is exchanged.
Accrual accounting is a method that records financial transactions when they occur, rather than when cash is exchanged. This approach provides a comprehensive view of a business’s financial health by matching revenues with the expenses incurred to generate them. It helps businesses understand their true profitability and obligations, regardless of the immediate flow of cash.
Understanding Accrual Accounting
At its core, accrual accounting operates on two fundamental principles: revenue recognition and the matching principle. The revenue recognition principle dictates that revenue should be recorded when it is earned and realized, which means when goods or services have been delivered or performed, regardless of when payment is received. For instance, if a consulting firm completes a project for a client in December, the revenue is recognized in December, even if the client pays in January.
The matching principle requires that expenses be recognized in the same accounting period as the revenues they helped produce. This ensures that the true cost of generating revenue is reflected accurately. For example, if a company pays its sales representatives a commission based on December sales but pays them in January, the commission expense is recorded in December to align with the revenue it helped create. This approach provides a clearer picture of profitability.
Accrual Basis Versus Cash Basis
Accrual accounting stands in contrast to the cash basis of accounting, which recognizes revenues and expenses only when cash changes hands. Under the cash basis, income is recorded when cash is received, and expenses are recorded when cash is paid out, making it a simpler method to track immediate cash flows. This method is often employed by very small businesses or individuals due to its straightforward nature.
The primary difference lies in the timing of recognition for transactions. For example, if a business completes a service in June and sends an invoice, under accrual accounting, the revenue is recorded in June. Under the cash basis, that revenue would only be recorded in July when the payment is actually received. Similarly, if a utility bill is received in March but paid in April, accrual accounting records the expense in March, while cash basis accounting records it in April.
Accrual accounting is generally preferred for most businesses, particularly larger ones, because it offers a more accurate depiction of financial performance over time. It considers all earned revenues and incurred expenses, providing a comprehensive view of profitability and financial obligations. This method aligns with Generally Accepted Accounting Principles (GAAP), which are the common set of accounting standards used in the United States. While the IRS allows some small businesses to use the cash method, those with average annual gross receipts above a certain threshold, currently $29 million, are required to use the accrual method for tax reporting.
Common Accrual Concepts
Accrued revenues represent income that has been earned but not yet received in cash. For instance, a landscaping company that completes weekly lawn maintenance for a client might bill at the end of the month; the revenue for each completed service is accrued before the invoice is sent.
Accrued expenses are costs that have been incurred but not yet paid. A common example is employee wages earned during the last week of a month but paid on the first Friday of the following month. The expense for those wages is recorded in the month they were worked.
Deferred revenues, also known as unearned revenues, occur when a business receives cash for goods or services it has not yet delivered or performed. If a customer pays upfront for a year-long subscription service, the entire amount is initially recorded as a liability. As the service is provided over the year, a portion of this liability is recognized as earned revenue each month.
Deferred expenses, or prepaid expenses, are payments made in advance for expenses that will be incurred in a future period. When a business pays for a 12-month insurance policy upfront, the entire payment is recorded as an asset. Each month, as a portion of the insurance coverage is used, that portion is then recognized as an expense, aligning the cost with the period of benefit.